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Tuesday, March 6, 2012

The Traditional Tools of Monetary Policy

Since monetary policy is controlled by the central bank of a country, let's begin our discussion with central banking. This entry will also discuss the tools used by central banks to manage the economy.

The Central Bank and the Money Supply 

A central bank has two main goals. The first one is to maintain low and stable inflation. The second one is to achieve high and stable growth and a low unemployment rate. To meet these policy goals, a central bank changes the money supply to raise or lower the interest rate. A changing interest rate in turn affects consumption and investment decisions, which are two of the important components in a country’s economic activities. The control of money supply gives a central bank the means to stimulate a weak economy and cool down an overheating economy when necessary.

Money supply, defined as the product of the monetary base and the money multiplier, reflects the liquidity supplied to the economy by the financial system. The monetary base includes both the currency in circulation and the reserves in commercial banks, whereas the money multiplier reflects the demand for loans and the willingness of banks to lend. For example, if either the demand for or the supply of loans increases, the money multiplier increases. More credit is created holding the monetary base constant.

Monetary Tools: Minimum Reserve Requirement and the Discount Window

Traditionally, there are three ways to indirectly control the money supply, namely the required minimum reserve ratio, the discount window and the open market operations. In countries where the bond markets lack depth and liquidity (such as China), central banks usually adjusts the reserve requirement in order to restrict or loosen credit. This gives the central bank control over the money multiplier.

The discount window allows banks to borrow from the central bank at the discount rate. But this rarely happens in practice because banks can often borrow at a lower cost elsewhere. Only when a bank is in trouble will it borrow from the central bank, which acts as the lender of last resort.

The Most Important Monetary Tool: Open Market Operations

In many countries, central banks carry out monetary policy in the form of open market operations, because they can be implemented quickly and reversed easily. In many countries, central banks carry out monetary policy in the form of open market operations, because they can be implemented quickly and reversed easily.

Open market operations refer to the purchase and sale of government bonds by the central bank. To inject liquidity into the economy, the central bank buys bonds from the market (and pay money to the market participants). The increase in the demand for bonds will push up bond prices.

Since bonds make fixed payments at specified time, a higher price means that the interest rate (or bond yield, to be more exact) decreases. To tighten liquidity, the central bank sells bonds to market participants (and collect money from them). The increase in the supply of bonds will push down bond prices and raises the interest rate. What we’ve applied here is the inverse relationship between bond prices and interest rates/yields, which is an important concept in economics and finance.

Monetary Policy Rule

Though there are still disputes among economists, most research studies have shown that central bank transparency and credibility can make monetary policy more effective by reducing private sector uncertainty and keeping market expectations in line with its own. Ben Bernanke, Chairman of the Federal Reserve, is precisely trying to communicate with the public on Fed policies and increase the transparency and credibility of U.S. monetary policy.

A predetermined monetary rule can increase transparency and credibility, and is widely believed to work better than discretionary policy. In particular, many central banks set the interest rate target according to the Taylor rule. It states that the central bank should raise the nominal interest rate when output is above the equilibrium level and/or when inflation is above the equilibrium rate. 


Abel, A. B., Bernanke, B. S., & Croushore, D. (2007). Macroeconomics (6th ed.). Boston, MA: Pearson/Addison Wesley.

Case, K. E., Fair, R. C., & Oster, S. C. (2009). Principles of economics (9th ed.). Upper Saddle River, NJ: Prentice Hall.

Mishkin, F. S. (2010). The economics of money, banking and financial markets (9th ed.). Boston, MA: Pearson Education.

(Entry 1 of 4 in the An Introduction to Monetary Policy series) 

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