There are three common monetary policy tools: open market operations, the refinancing rate, and reserve requirements.
Open market operations
In the open market operations, a central bank may purchase government bonds from banks and other market makers, which increases their reserves which in turn may increase lending and increase the broad money supply through the process of credit creation. The opposite occurs when a central bank buys back government bonds.
The most obvious expression of monetary policy is through the policy rate, which is the rate at which central banks lend money to the commercial banks. Since this occurs through the execution of repurchase agreements, whose maturity varies from overnight to two weeks, it is also called repo rate. When the central bank increases its policy rate, it causes commercial banks to increase their base rates which decrease credit creation.
Different countries have different names for the policy rate, for example in the UK, it is called a two-week repo rate, the European Central Bank calls it the refinancing rate, and in the US, it is called the discount rate. However, the US Federal Reserve ultimately targets a specific federal funds rate, the rate at which banks trade their reserves with each other.
If central banks increased required reserves, banks can lend less of their deposits and this decreases broad money and vice versa. However, this policy tool is used less often by developed countries because it is potentially disrupting.
Test your knowledge
Which of the following monetary policy tool is less frequently used by developed economies?
A) Open market operations
B) Policy rate
C) Reserve requirement
C is correct. Even though developing economies continue to use reserve requirements, developed economies have been using it less frequently due to their potentially disrupting effect.