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101 Concepts for the Level I Exam

Concept 31: Tools Used to Implement Monetary Policy


The three tools available to central banks to control the money supply are:

Policy rates

  • Borrowing from central bank:
  • Banks can borrow from central bank to meet shortfall in reserves at a rate called discount rate or refinancing rate or repo rate. This is facilitated through repurchase agreements.
  • A lower repo rate increases money supply and encourages lending, this lowers interest rates.
  • On the other hand, a higher repo rate decreases money supply and reduces lending, this increases interest rates.
  • Interbank lending:
  • Banks can lend to each other overnight loan reserves at a rate called federal funds rate (for US banks).
  • Fed uses open market operations to move it to the targeted rate.

Open market operations

  • Central bank buys securities →Investors and banks get cash →increases banks excess reserves → increases money supply and encourages lending →lowers interest rates.
  • Central bank sells securities → Investors and banks pay cash → lowers bank excess reserves → decreases money supply and reduces lending → increases interest rates.
  • Frequently used in US.

Reserve requirements

  • Represents the deposits to be maintained to meet withdrawal limits.
  • Increase in reserve requirement →decreases money supply and reduces lending →increases interest rates.
  • Decrease in reserve requirement →increases money supply and encourages lending → decreases interest rates.