Monetary Policy Instruments
Monetary policy is the process by which a government, central bank, or monetary authority affects the availability and cost of money and credit, thus influencing the behavior of economic agents. The monetary policy instruments used in practice by the Federal Reserve System in the United States, as well as by many other central banks, are generally divided into two broad categories: those that affect the quantity of reserves and those that affect the cost of reserves.
Reserve quantities refer to the overall amount of money in circulation, while the cost of reserves refers to the interest rate charged to banks when they borrow funds from the central bank. Central banks use both quantity and cost instruments to affect the money supply in the economy. The most widely used quantity instruments are open market operations and reserve requirements. Open market operations are the buying and selling of government securities in the marketplace by the central bank in order to affect the level of banking reserves. Reserve requirements are the amount of funds that banks must set aside in their vaults against deposits and other liabilities.
The two most commonly used cost instruments of monetary policy include changes in the discount rate and changes in the federal funds rate. The discount rate is the rate at which eligible depository institutions can borrow reserves from their regional Federal Reserve Bank. The federal funds rate is the overnight rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. A change in either of these rates affects the cost of reserves available to banks and thereby influences the amount of reserve lending and borrowing.
In addition to the two primary categories of monetary policy instruments, there are also a variety of less commonly used instruments. These include the Lombard rate, the European Central Bank’s marginal lending facility rate, the central bank’s penal rate, and the selective credit controls. The Lombard rate is the rate at which the central bank charges commercial banks when they borrow reserves to meet regulatory reserve requirements. The marginal lending facility rate is the rate at which the European Central Bank makes available certain refinancing operations to commercial banks. The penal rate is the rate charged to banks that are deemed to have inadequate reserves. Selective credit controls are measures used by central banks to encourage or discourage particular types of borrowing by adjusting interest rate ceilings or floors on loans of different types.
In recent years, central banks have also begun to make use of non-traditional monetary policy instruments, including forward guidance and quantitative easing. Forward guidance is a method of influencing the behavior of economic agents by communicating the central bank’s expectations about future monetary policy. Quantitative easing is the central bank’s purchase of household, corporate, or government debt in order to inject liquidity into the financial markets. Both of these instruments are used to ensure that credit remains readily available and that the money supply remains at an appropriate level.
In conclusion, there are a variety of monetary policy instruments available to central banks for the purpose of influencing the availability and cost of money and credit. The most important of these instruments are open market operations, reserve requirements, the discount rate, and the federal funds rate. Additionally, central banks have begun to make use of non-traditional instruments such as forward guidance and quantitative easing. Ultimately, the success of any particular monetary policy instrument depends on its ability to achieve the desired outcome of increasing or decreasing the amount of money in circulation.
