Explain the 4 Tools of Monetary Policy and give examplesSolu

Explain the 4 Tools of Monetary Policy and give examples

Solution

In order to implement monetary policy, the central bank uses following tools :-

1) open-market operations (OMO) :- open market operations refers to buying and selling of government securities in open market. In USA, OMO are conducted by federal reserve bank of New York. It is the most frequently used tool of monetary policy, because of it is most flexible way to intervene money supply of economy. For example, to increase money supply central bank purchase securities from banks and this leads to excess reserve with bank so bank lend All the excess money with them and supply of money increases is economy.

2) discount rate :- discount rate is the interest fee charged by central bank on loans taken by banks from central bank.
There are three discount rate, primary credit rate, secondary credit rate and seasonal rate. a higher discount rate means that bank would borrow less from central bank as it is more expensive.
For example Central bank increases discount rate when it want interest rates to rise. It is called contractionary monetary policy and opposite to it is expansionary monetary policy, when central bank decreases discount rate and it leads to lowering of interest rate.

3) required reserve ratio:- RRR is percentage of depositor\'s balance, that commercial banks are required to hold with them as cash, according to directions of central bank.
If central bank decides to decrease RRR, commercial banks are required to hold less cash and it will increase the amount available to lend and it will leads to lower interest rates and excess money supply in economy and vise versa.

4) fed fund rate :- the federal funds rate is the interest fee at which financial institutions(banks, thrifts, credit unions) lend money to each other. Fed fund rates influences short term interest rates, for example a high fed fund rate discourages banks from borrowing from each other, and that leads to decrease the money supply in economy.

Hope it helped.

Comment if you need more help with this.

Good luck.