Therefore, central banks can only control the amount of money in the economy indirectly through what we call monetary policy. More specifically, they can resort to three main monetary policy tools to control the money supply: 1 open market operations, 2 the discount rate, and 3 reserve requirements.
We will look at each of those tools in more detail below. Open market operations are a means to control the money supply by buying or selling bonds on the bond market i. That means, the central banks create new money and exchange it for bonds on the open market to increase the amount of currency in circulation or vice versa. To illustrate this, assume the Federal Reserve Bank Fed wants to increase the money supply in the US to prevent a recession.
To do this, it can create new US dollars and buy existing bonds on the open market with the newly created cash. This puts the new dollars in circulation and thereby increases the money supply. Conversely, to reduce the money supply, the Fed can sell some of the bonds from its portfolio on the open market and thereby reduce the amount of USD in circulation. These kinds of open market operations are sometimes also referred to as outright open market operations.
That means, the Fed can increase the cost of borrowing money for commercial banks which reduces the demand for new capital and vice versa. For example, if the Federal Reserve wants to stimulate the economy by increasing the money supply, it can do so by lowering the discount rate. From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change.
When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.
The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market.
Suppose the Fed wants the funds rate to fall. To do this, it buys government securities from a bank. As a result, the bank now has more reserves than it wants. So the bank can lend these unwanted reserves to another bank in the federal funds market. When the Fed wants the funds rate to rise, it does the reverse, that is, it sells government securities. The Fed receives payment in reserves from banks, which lowers the supply of reserves in the banking system, and the funds rate rises.
Since January , the discount rate has been set basis points above the funds rate target, though the difference between the two rates could vary in principle. Setting the discount rate higher than the funds rate is designed to keep banks from turning to this source before they have exhausted other less expensive alternatives. She is the President of the economic website World Money Watch.
As a writer for The Balance, Kimberly provides insight on the state of the present-day economy, as well as past events that have had a lasting impact. Erika Rasure, is the Founder of Crypto Goddess, the first learning community curated for women to learn how to invest their money—and themselves—in crypto, blockchain, and the future of finance and digital assets. She is a financial therapist and is globally-recognized as a leading personal finance and cryptocurrency subject matter expert and educator.
Central banks have four main monetary policy tools: the reserve requirement, open market operations, the discount rate, and interest on reserves. Most central banks also have a lot more tools at their disposal. Here are the four primary tools and how they work together to sustain healthy economic growth.
The reserve requirement refers to the money banks must keep on hand overnight. They can either keep the reserve in their vaults or at the central bank.
A low reserve requirement allows banks to lend more of their deposits. It's expansionary because it creates credit. A high reserve requirement is contractionary.
It gives banks less money to lend. It's especially hard for small banks because they don't have as much to lend in the first place. That's why most central banks don't impose a reserve requirement on small banks. Central banks rarely change the reserve requirement because it's difficult for member banks to modify their procedures. Open market operations are when central banks buy or sell securities. These are bought from or sold to the country's private banks. When the central bank buys securities, it adds cash to the banks' reserves.
That gives them more money to lend. When the central bank sells the securities, it places them on the banks' balance sheets and reduces its cash holdings. The bank now has less to lend. A central bank buys securities when it wants an expansionary monetary policy. It sells them when it executes contractionary monetary policy.
The U. Federal Reserve uses open market operations to manage the fed funds rate. Here's how the fed funds rate works. If a bank can't meet the reserve requirement, it borrows from another bank that has excess cash. The amount borrowed is called fed funds. The interest rate it pays is the fed funds rate. It uses open market operations to encourage banks to meet the target.
Quantitative easing QE is open market operations that purchase long-term bonds, which has the effect of lowering long-term interest rates. It added or subtracted to affect policy, but kept it within that range. This rate is the benchmark for all short-term interest rates. The Fed then needed to implement QE as a secondary tool, to keep long-term interest rates low.
As the economy improved, it allowed these securities to expire, in the hopes of normalizing its balance sheet.
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