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What Are the Different Types of Monetary Policy Tools?

Nicole Long
Nicole Long

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.

The Federal Reserve Bank employs a number of monetary policy tools.
The Federal Reserve Bank employs a number of monetary policy tools.

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.

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Discussion Comments


@nony - It might, but the Federal Reserve will protect them to a certain amount. People don’t need to do a run on the banks. There is something called Federal Deposit insurance which will protect you up to $100,000 per account. Of course you can open up multiple accounts if you have more than that amount of money.

Overall, I think the Federal monetary policy is good, but it needs to be exercised with restraint. I personally believe the actions of the Federal Reserve can prevent the economy from going into a tailspin when done correctly.


@everetra - What do you think of the reserve requirements? Isn’t it dangerous to decrease the reserve requirement? If you do that, then banks don’t have to have as much cash on hand to cover their lending. I would think that this would expose them to added risk, wouldn’t you think?


@hamje32 - That may be true, but lowering the discount rate is not in itself bad. It’s just what banks choose to do as a result that is at issue.

With some of the other tools of monetary policy, however, I think the usefulness of the Federal Reserve’s actions is questionable. Take the Federal Open Market tool.

Okay, so they buy treasuries to put money into the economy. If they do this too much, there is too much money in the economy and what does that do to the value of the dollar? Do you see what I mean?

Personally, I believe that the Federal Reserve should steer clear of aggressive maneuvers to try to stimulate the economy. In my opinion I think Congress is more qualified to do that, by reducing tax rates. Reducing tax rates always increases revenue to the treasury.


Some of the tools of monetary policy don’t always work as intended in my opinion. Take the decision to lower the discount rate.

While in principle this makes it more affordable for banks to lend, they don’t always lend. Sometimes they sit on their cash, and we’re talking a lot of cash.

What is the reason for this? They do it in times of economic recession, where there are no clear signals about which way the economy is heading. Banks want to minimize risk as much as possible.

So they don’t want to lend if they think there is a big possibility of default. Therefore they just sit and wait things out. I’m not saying this always happens, but sometimes it does.

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    • The Federal Reserve Bank employs a number of monetary policy tools.
      By: adamparent
      The Federal Reserve Bank employs a number of monetary policy tools.