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What are the tools of monetary policy?

Posted on April 18, 2014 at 10:25 AM

The Federal Reserve (central bank) has several tools of monetary policy that influences money supply and interest rates. Here are the major monetary policy tools:

1. Open Market Operations: When the Fed buys and sells government bonds (or securities) to change the money supply and interest rates. The Fed targets the federal funds interest rate (bank-to-bank interest rate for short-term loans) through open market operations. If the Fed wants to increase money supply and reduce interest rates, then it buys bonds. If the Fed wants to reduce the money supply and increase interest rates, then it sells bonds.

2. Discount Rate: The Fed can increase or decrease the interest rate it charges banks for short-term loans. When the Fed lowers the discount rate, the money supply increases. When it raises the discount rate, the money supply decreases.

3. Reserve Requirement: The Fed can reduce the reserve ratio, which means banks can lend more of its excess reserves to increase the money supply. It can also raise the reserve ratio, which reduces a bank's excess reserves and the money supply.

Wild Card. Interest Paid on Bank Reserves: As a result of the Great Recession (2007-2009), the Fed began paying interest on bank reserves held at the Fed. As of 2014, this tool is still considered experimental and we do not know the true effects of this policy tool.

AP Macroeconomics Unit 4 Monetary Policy

Categories: AP Macroeconomics, Macro Unit 4 Monetary Policy

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