The central bank of a country, such as the Federal Reserve Bank in the United States, has the ability to use monetary policy tools to help a nation reach a desired economic position. These monetary policy tools help promote output and employment, and also work to keep prices stable within an economy to ward off inflation. Changing the discount rate, changing the reserve requirements, and participating in open market operations represent the different monetary policy tools available to a country’s central bank.
Controlling the discount rate, the rate of interest used by a central bank when loaning money to other banks, is one of the monetary policy tools available to a nation’s central bank. These loans, considered discount loans, can help banks meet reserve requirements. They also maintain a sufficient balance to cover depositor withdraws.
Changing the discount rate brings about two scenarios. When the central bank raises the discount rate, loans become more expensive to banks. This can result in a decrease in the available money in the marketplace to loan to private consumers and investors. A reduction in the discount rate may spur banks to increase borrowing, and thus result in an increased opportunity for private and commercial loans.
Reserve requirements equal the amount of cash the central bank requires other banks to have on hand to cover withdraws and unexpected outflows. Raising the reserve requirements may take away from the amount of money a bank has available to lend. Reducing the reserve requirements can allow banks to loosen lending policies, and put more money in the hands of consumers, producers, and investors.
Open market operations represent the main tool used by a central bank when enacting monetary policy. In the case of the United States, the Federal Reserve buys or sells government securities, typically treasury bills, to impact the availability of money in the economy. When the Federal Reserve invests in government securities, more funds circulate through the economy via the banking system. If government securities are sold, however, less money circulates through the economy.
Not all countries fall under this same model of monetary policy, though most developed nations do maintain a central banking authority that implements similar policies. When monetary policy tools are used to increase the money supply, the central bank is trying to encourage consumers and corporations to invest, spend, and accelerate economic growth. A decrease in money supply can slow down economic growth and help prevent inflation when the economy is approaching ideal employment, output, and price stability.