What are some of the Fed's monetary policy tools to tackle inflation? How do these tools affect our lives? What's the importance of monetary policy tools in an economy, and what happens if the Fed gets it wrong? You will be able to answer all these questions once you read our explanation on Monetary Policy Tools! Let's dive in!
Monetary Policy Tools Meaning
What do economists mean when they use the term - monetary policy tools? Monetary policy tools are tools that the Fed uses to ensure economic growth while controlling the supply of money and the aggregate demand in the economy.But let's start from the beginning.
Economies around the world and the U.S. are prone to periods characterized by instability in terms of growth and price level. There are periods that are characterized by a significant increase in price levels, such as the one that many countries around the world are experiencing currently, or periods where aggregate demand falls, which hinders economic growth, creating less output in a country and increasing unemployment.
To deal with such fluctuations in the economy, countries have central banks. In the U.S. the Federal Reserve System serves as the central bank. These institutions ensure that the economy goes back on track when there is turmoil in the markets. The Fed uses specific tools aimed to target the economic shocks that are causing havoc in the economy. These tools are known as monetary policy tools.
Monetary policy tools are tools that the Fed uses to ensure economic growth while controlling the supply of money and the aggregate demand in the economy.
Monetary policy tools allow the Fed to exercise control of the total supply of money by impacting the money available to consumers, businesses, and banks. Although in the United States, the Treasury Department has the capacity to issue money, the Federal Reserve has a significant impact on the money supply through the use of monetary policy tools.
One of the main tools is the open market operations which involve buying securities from the market. When the Fed wants to ease the monetary policy, it buys securities from the public, thereby injecting more money into the economy. On the other hand, when it wants to tighten its monetary policy, the Fed sells securities to the market, which in turn reduces the money supply, as the funds are flowing from the hands of investors to the Fed.
The main objective of monetary policy tools is to keep the economy humming along at a steady but not too high or low pace of growth. Monetary policy tools help achieve macroeconomic goals such as price stability.
Types of Monetary Policy Tools
There are three main types of monetary policy tools:
- open market operations
- reserve requirements
- the discount rate
Open Market Operations
When the Federal Reserve purchases or sells government bonds and other securities, it is said to be conducting open market operations.
To enhance the amount of money available, the Federal Reserve orders its bond traders at the New York Fed to purchase bonds from the general public on the nation's bond markets. The money that the Federal Reserve pays for the bonds adds to the total amount of dollars in the economy. Some of these additional dollars are stored as cash, while others are put in bank accounts.
Each additional dollar kept as currency results in a one-to-one increase in the money supply. A dollar put in a bank, however, raises the money supply by more than one dollar since it increases banks' reserves, thereby increasing the amount of money that the banking system may generate due to the deposit.
Check our article on Money Creation and the Money Multiplier to better understand how one dollar in reserves helps create more money for the whole economy!
The Federal Reserve does the inverse to shrink the money supply: it sells government bonds to the general public on the nation's bond markets. As a result of purchasing these bonds with their cash and bank deposits, the general public contributes to lowering the quantity of money in circulation. Furthermore, when consumers withdraw money from their bank accounts to purchase these bonds from the Fed, banks find themselves with a lower amount of cash on hand. As a result, banks limit the quantity of money they lend, causing the money-creation process to reverse its direction.
The Federal Reserve may employ open-market operations to alter the money supply by a small or large amount on any given day without requiring substantial changes to laws or bank rules. As a result, open-market operations are the monetary policy instrument that the Federal Reserve employs the most often. Open-market operations have a greater impact on the money supply rather than the monetary base due to the money multiplier.
Open market operations refer to the Federal Reserve purchasing or selling government bonds and other securities on the market
Reserve Requirement
The Reserve requirement ratio is one of the monetary policy tools used by the Fed. The Reserve requirement ratio refers to the amount of funds banks must keep in their deposits.
The amount of money that the banking system can create with each dollar of reserves is influenced by reserve requirements. A rise in reserve requirements implies that banks will be required to retain more reserves and will be able to loan out less of each dollar that is deposited. This then reduces the money supply in the economy as banks aren't capable of lending as much money as before. A drop in reserve requirements, on the other hand, decreases the reserve ratio, boosts the money multiplier, and increases the money supply.
Changes in reserve requirements are only used in exceptional circumstances by the Fed since they disrupt the banking industry's operations. When the Federal Reserve raises reserve requirements, certain banks may find themselves short of reserves, despite their deposits having remained unchanged. Consequently, they must restrain lending until they have increased their level of reserves to the new minimum requirement.
The Reserve requirement ratio refers to the amount of funds banks must keep in their deposits
When banks fall short of their reserves, they go to the federal funds market, which is a financial market that allows banks that fall short of their reserves to borrow from other banks. Usually, this is done for short periods of time. Although this market is determined by demand and supply, the Fed has a considerable influence. The equilibrium in the federal funds market forms the federal funds rate, which is the rate at which banks borrow from one another in the federal funds market.
Discount Rate
The discount rate is another important monetary policy tool. Through the loan of funds to banks, the Federal Reserve may also enhance the money supply in the economy. The interest rate on loans made to banks by the Federal Reserve is known as the discount rate.
In order to fulfill regulatory requirements, meet depositor withdrawals, originate new loans, or for any other business purpose, banks borrow from the Federal Reserve when they believe they do not have enough reserves on hand to meet those requirements. There are many ways commercial banks can borrow money from the Federal Reserve.
Banking institutions traditionally borrow money from the Federal Reserve and pay an interest rate on their loan, which is known as the discount rate. As a result of the Fed's loan to a bank, the banking system ends up with more reserves than it would have otherwise, and these increased reserves enable the banking system to produce more money.
The discount rate, which the Fed controls, is adjusted to affect the money supply. An increase in the discount rate makes banks less likely to borrow reserves from the Federal Reserve. As a result, a rise in the discount rate decreases the number of reserves in the banking system, thereby reducing the amount of money available for circulation. On the other hand, a lower discount rate encourages banks to borrow from the Federal Reserve, thus boosting the number of reserves and the money supply.
The discount rate is the interest rate on loans made to banks by the Federal Reserve
Examples of Monetary Policy Tools
Let's go over some of the examples of monetary policy tools.
During the stock market collapse of 1987, for example, several Wall Street brokerage companies found themselves momentarily in need of capital to support the enormous volume of stock trading that was taking place at the time. The Federal Reserve lowered the discount rate and pledged to act as a source of liquidity to prevent the economy from collapsing.
A decline in house values throughout the United States in 2008 and 2009 resulted in a substantial increase in the number of homeowners who defaulted on their mortgage debts, causing many financial institutions that held those mortgages to get into financial problems as well. For a number of years, the Federal Reserve offered billions of dollars in loans by lowering the discount rate to financially distressed institutions in an effort to avoid these events from having larger economic reverberations.
A recent example of monetary policy tools used by the Fed includes the open market operations in response to the Covid-19 economic crisis. Referred to as quantitative easing, the Fed purchased massive amounts of debt securities, which helped inject a significant amount of money into the economy.
Importance of Monetary Policy Tools
The importance of monetary policy tools comes from it directly having an impact on our daily lives. Effective use of monetary policy tools would help tackle inflation, reduce unemployment numbers and promote economic growth. If the Fed were to recklessly choose to lower the discount rate and flood the market with money, the prices of literally everything would skyrocket. This would mean that your purchasing power would decrease.
Monetary policy tools have a significant influence on the aggregate demand curve. The reason for that is that monetary policy directly impacts the interest rate in the economy, which then affects consumption and investment spending in the economy.
Fig. 1 - Monetary policy tools affect aggregate demand
Figure 1 shows how monetary policy tools can affect the aggregate demand in an economy. The aggregate demand curve can shift to the right causing an inflationary gap in an economy with higher prices and more output produced. On the other hand, the aggregate demand curve can shift to the left due to monetary policy tools, leading to a recessionary gap associated with lower prices and lower output produced.
If you want to learn more about monetary policy check out our article - Monetary Policy.
And if you want to find out more about inflationary and recessionary gaps, check out our article - Business Cycles.
Think about when Covid-19 happened and everyone was in lockdown. Many people were losing their jobs, businesses were collapsing as aggregate demand dropped. The use of monetary policy tools helped bring the U.S. economy back to its feet.
Uses of Monetary Policy Tools
The main uses of monetary policy tools are to promote price stability, economic growth, and stable long-term interest rates. The Fed constantly uses monetary policy tools to address critical economic developments that could hinder economic growth and stability.
When prices are really high, and consumers lose a significant portion of their purchasing power, the Fed might consider using one of its monetary tools to bring the aggregate demand down. For instance, the Fed could increase the discount rate, making it more expensive for banks to borrow from the Fed, making loans more expensive. This would cause a fall in consumer and investment spending, which would lower aggregate demand and therefore prices in the economy.
Find out more about how the Fed maintains a stable economy by checking our explanation - Macroeconomic Policy.
Monetary Policy Tools - Key Takeaways
- Monetary policy tools are tools that the Fed uses to ensure economic growth while controlling the supply of money and the aggregate demand in the economy.
- Monetary policy tools control the total supply of money by impacting the money available to consumers, businesses, and banks.
- Although in the United States the Treasury Department has the capacity to issue money, the Federal Reserve has a significant impact on the money supply through the use of monetary policy tools.
- There are three main types of monetary policy tools: open market operations, reserve requirements, and discount rate.
- The importance of monetary policy tools comes from it directly having an impact on our daily lives.
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