The Tools of Monetary Policy
1. Open Market Operations
2. Discount Loans
3. Changes in Reserve Requirements
1 Open Market Operations
The two types of open market operations are:
Open market purchases = Central Bank buys Government securities to increase the monetary base.
Open market sales = Central Bank sells Government securities to decrease the monetary base.
Thus, the Central Bank conducts open market operations by buying and selling Government securities–especially Treasury bills.
Since the market for Treasury bills is so active, the Central Bank can make large purchases and sales quickly and easily, without disrupting the market.
Open market purchases and sales have permanent affects on the monetary base, but some-times the Central Bank will want to change the monetary base only temporarily. At these times, it engages in two other types of transactions:
Repurchase Agreement (repo) = The Central Bank purchases Government securities will an agreement that the seller will buy them back (repurchase them) at a specified price on a specified date, usually within two weeks. A repo is therefore like a temporary open market purchase, temporarily increasing the monetary base.
Matched Sale-Purchase Transaction (reverse repo) = The Central Bank sells Government securities with an agreement that the buyer will sell them back at a specified price on a specified date, again usually within two weeks. A reverse repo is therefore like a temporary open market sale, temporarily decreasing the monetary base.
2 Discount Loans
When a bank receives a discount loan from the Central Bank, it is said to have received a loan at the “discount window.”
The Central Bank can affect the volume of discount loans by setting the discount rate:
A higher discount rate makes discount borrowing less attractive to banks and will therefore reduce the volume of discount loans.
A lower discount rate makes discount borrowing more attractive to banks and will therefore increase the volume of discount loans.
Discount lending is most important during financial panics:
When depositors lose confidence in the financial system, they will rush to withdraw their money.
This large deposit outflow puts the banking system in great need of reserves.
The Central Bank stands ready to supply these reserves by making discount loans.
In such situations, the Central Bank acts as a lender of last resort.
Advantage of discount loans:
They allow the Central Bank to act as a lender of last resort during a financial panic.
Disadvantages of using discount loans as a tool for monetary policy during normal times:
The volume of discount loans can be influenced by the Central Bank, but not completely con-trolled: The Central Bank cannot be sure how many banks will request discount loans at any given interest rate.
Changes in the discount rate must be proposed by the Central Bank before being approved by the Board of Governors. Hence, they are neither quickly made nor easily reversed.
3 Changes in Reserve Requirements
By affecting the money multiplier, changes in the required reserve ratio can lead to changes in the money supply.
Disadvantages to using changes in reserve requirements as a tool for monetary policy:
Large changes in reserves must be approved by Board of Governors.
Hence, large changes cannot be made quickly and easily.
Also, if a bank holds only a small amount of excess reserves and the required reserve ratio is increased, the bank will have to quickly acquire reserves by borrowing, selling securities, or reducing its loans. Each of these three options is costly and disruptive.
Hence, changes in reserve requirements can cause problems for banks by making liquidity management more difficult.
Conclusion
Open market operations are by far the most effective tool with which the Central Bank can conduct monetary policy on a day-to-day basis.
Thus, in practice, the Central Bank relies most heavily on open market operations in conducting monetary policy.
