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Central Bank Monetary Policy Tools

Economics and Currency

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Monetary Policy Tools

Central banks have a set of monetary policy tools that they can use to accomplish their mandates. Monetary policy tools vary in suitability and preference by the central bank. Certain monetary policy tools are more likely to be used in certain situations than others. The tools consist of three specific options: Reserve Requirements, Discount Rates, and Open Market Operations. In totl, banks have roughly six economy controlling options, including Reserve Requirements, Interest Rates, Open Market Operations, Repurchase Agreements, Discount Window Lending, Quantitative Easing, and Signaling or Language. Some combination of these tools usually will result in economic changes the bank desires.

Reserve Requirements

Central Bank Reserve Requirements restrict the amount of money commercial banks must keep on deposit. Commercial banks use deposited funds to lend money at interest, earning the bank future capital. A higher reserve requirement requires more capital be kept within the bank. A lower reserve requirement allows more money to be lent.

Reserve Requirements directly controls the money supply, which has an impact on inflation and deflation suffered by the economy. More lending results in a higher money supply, more money in the economy, and more inflation. Less lending results in a lower money supply, less money in the economy, and lower inflation.

Interest Rates

Contrary to popular opinion, interest rates are targeted and not set. There is no direct way for a bank to set the interest rate, which is set via supply and demand factors within the marketplace. They can only modify the Discount Rate (overnight loan rate), which has a cascading influence on other interest rates but does not directly control the interest rate. A cheaper rate means a higher money supply since borrowing is cheaper. A higher rate means a lower money supply since buying is more expensive.

Open Market Operations

An Open Market Operation occurs when the bank directly intervenes in the market. This intervention changes both the securities targeted by the open market operation and the money supply in the economy. The target is typically government bonds/securities.

Buying assets result in more money supply since the central bank is effectively handing the market money in exchange for the asset. This raises the inflation rate. This action also increases the price of the targeted security. Note that this variation of open market operations can cost the central bank money, so it typically is not widely used.

Selling assets results in less money supply since the central bank is acquiring money from the market in exchange for the asset. This lowers the inflation rate. It also decreases the price of the security targeted for acquisition.

Repurchase Agreements

A Repurchase Agreement is a shorter term alteration of the market. During a repurchase agreement, a party sells securities to another party and agrees to purchase the securities back the next day (or within a short period of time). It is essentially a short-term loan, with the asset sold being collateral. Repurchase agreements are supposed to have no risk, so collateral usually takes the form of government-backed riskless assets like treasuries.

Central Banks regulate the money supply utilizing repurchase agreements over extremely short terms, but repurchase agreements are so common they have very little impact on the marketplace. In most cases, they are short term or overnight, and usually have a maximum time frame of a week.

Discount Window Lending

Discount lending is a Central Bank tool that reduces potential liquidity issues within bank sectors. The goal of this tool is not to manipulate interest rates or money supply, but smoothen potential issues that could occur in the banking sector.

Discount Window Lending lets banks borrow at below market interest rates. This is useful if a commercial bank is suffering from a short-term liquidity issue. The temporary capital loan smoothens the bank’s capital gap and also can prevent worse situations like bank runs. This stabilizes the banking sector and smoothens the economy’s growth.

Quantitative Easing

Quantitative Easing involves the purchase or sale of assets to control the money supply, usually using government bonds. When an economy is stalled, easing involves buying massive amounts of market securities. The increase in the money supply stimulates the economy, hopefully bringing GDP output and the inflation rates back where the central bank wants them. QE is typically only used in dire economic straits and is considered an unconventional strategy.

Quantitative easing is usually best combined with other tactics for controlling the economy’s money supply. A central bank cannot force commercial banks to lend since they lack legislative power. The central bank will typically need to work with governments to force banks to lend capital to individuals and expand the money supply.

Signaling & Language

Signaling is the most benign form of Central Bank action. A central bank will literally state their desires, hoping the market does what it desires without it having to take any action. The central bank will threaten a course of action without taking it. If the market reacts, the bank will not have to take action, solving its problems. If the market doesn’t react, the bank will need to follow through on its desired course of action to bring the economy in line.

This requires the central bank to have credibility. A bank without credibility will not convince markets to react how it desires. If the bank doesn’t act, or cannot follow through, it will lose credibility. The market will not only refuse to act how it desires, it may worsen the problem by acting further in opposition to how the central bank desires.

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