Monetary Policy Tools

Recall that we assume money supply (\(M\)) set by central bank (e.g. Federal Reserve System).

Monetary Policy Basic

• The Federal Reserve’s three instruments of monetary policy are open market operations, the discount rate and reserve requirements.

  • Open market operations involve the buying and selling of government securities. Open market operations are flexible, and thus, the most frequently used tool of monetary policy.

    • Buying government securities to increase money supply, selling government securities to decrease money supply.

  • The discount rate is the interest rate charged by Federal Reserve Banks to depository institutions on short-term loans.

    • Cutting discount rate to increase money supply, raising discount rate to decrease money supply.

  • Reserve requirements are the portions of deposits that banks must maintain either in their vaults or on deposit at a Federal Reserve Bank.

    • Lower reserve ratio to increase money supply, higher reserve ratio to decrease money supply.

Open Market Operation

Monetary policy made by Federal Open Market Committee (FOMC) meeting, the corresponding open market operation is implemented by Federal Reserve Bank of New York.

• Set a target interest rate federal funds rate, then adjust money supply through open market operation until interest rate fall into the target interval. (e.g. Buying bonds from consumers to boost their money on hand in IS-LM model)

• Open Market Operation

• System Open Market Account Holdings of Domestic Securities