Definition: Monetary policy is how central banks manage the money supply to guide healthy economic growth. The money supply is credit, cash, checks, and money market mutual funds. The most important of these is credit, which includes loans, bonds, mortgages, and other agreements to repay. Monetary policy is the macroeconomic policy laid down by the central bank. It involves
The NRB implements the monetary policy through open market operations, bank rate policy, reserve system, credit control policy, and moral persuasion and through many other instruments. Using any of these instruments will lead to changes in the interest
For instance, liquidity is important for an economy to spur growth. To maintain liquidity, the NRB is dependent on the monetary policy. By purchasing bonds through open market operations, the RBI introduces money in the system and reduces the interest rate.
Central banks have three main tools of monetary policy: open market operations, the discount rate, and a bank’s reserve requirement. However, most banks have many more at their disposal. Here’s what they are, and how they all work together to sustain healthy economic growth.
- Open Market Operations
Open market operations are when central banks buy or sell securities from the country’s banks. When the central bank buys securities, adds cash to the banks’ reserves. This gives them more money to lend more. When the central bank sells the securities, it simply 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 expansionary monetary policy, and sells them when it executes contractionary monetary policy.
- Reserve Requirement
The reserve requirement refers to the deposit a bank must keep on hand overnight, either in its vaults or at the central bank. A low reserve requirement allows the banks to lend more of their deposits. That is expansionary because it creates more credit. A high reserve requirement is contractionary since it gives banks less money to lend. It’s especially hard on small banks since they don’t have as much to lend in the first place. Central banks rarely change the reserve requirement because it’s expensive and disruptive for member banks to change their procedures.
Instead, central banks are more likely to adjust their targeted lending rate because it achieves the same result. The Fed funds rate is perhaps the most well-known of these tools. Here’s how it works. If a bank can’t meet the reserve requirement, it borrows from another bank that has excess cash. The interest rate it pays is the Fed funds rate. The amount it borrows is called the Fed funds. The Federal Open Market Committee (FOMC) sets a target for the Fed funds rate at its meetings.
Central banks have several tools to make sure the Fed funds rate meets that target. The Federal Reserve, the Bank of England, and the European Central Bank pay interest on the required reserves and any excess reserves. Bank won’t lend Fed funds for less than the rate they’re receiving from the Fed for these reserves. Banks also use open market operations.
- Discount Rate
The discount rate is the third tool. It’s the rate that central banks charge its members to borrow at its discount window. Since the rate is higher, banks only use this if they can’t borrow funds from other banks.
How It Works
Central bank tools work by increasing or decreasing total liquidity. This includes both the total amount of capital available to invest or lend, as well as money to spend. In other words, it’s more than the money supply, which consists of M1, (currency and check deposits) and M2 (money market funds, CDs and savings accounts plus M1). Therefore, when people say that central bank tools affect only the money supply, they are understating the impact.
Compiled and collected by
Basudev Sharma Poudel(PHD)
Have a question? Ask us in our discussion forum.