Monetary Policy Implementation

A central bank has three traditional tools to implement monetary policy in the economy:

• Open market operations
• Changing reserve requirements
• Changing the discount rate

• The most common monetary policy tool in the U.S. is open market operations.
• These take place when the central bank sells or buys U.S. Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates.
• The specific interest rate targeted in open market operations is the federal funds rate. The name is a bit of a misnomer since the federal funds rate is the interest rate that commercial banks charge making overnight loans to other banks. As such, it is a very short term interest rate, but one that reflects credit conditions in financial markets very well.

• Is it a sale of bonds by the central bank which increases bank reserves and lowers interest rates or is it a purchase of bonds by the central bank? The easy way to keep track of this is to treat the central bank as being outside the banking system.
• When a central bank buys bonds, money is flowing from the central bank to individual banks in the economy, increasing the money supply in circulation.
• When a central bank sells bonds, then money from individual banks in the economy is flowing into the central bank—reducing the quantity of money in the economy.

• A second method of conducting monetary policy is for the central bank to raise or lower the reserve requirement, which is the percentage of each bank’s deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank.
• If banks are required to hold a greater amount in reserves, they have less money available to lend out. If banks are allowed to hold a smaller amount in reserves, they will have a greater amount of money available to lend out.

• The third traditional method for conducting monetary policy is to raise or lower the discount rate.
• If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserves from the Fed, and instead call in loans to replace those reserves.
• Since fewer loans are available, the money supply falls and market interest rates rise. If the central bank lowers the discount rate it charges to banks, the process works in reverse.