Question

Write a three page essay explaining the three main tools of monetary policy and how they work to change GDP, employment, and inflation.

Answer 1

Open Market Operations- Open market operations are when shares are bought or sold by central banks. These are purchased from or sold to the private banks of the world. This adds cash to the assets of the banks when the central bank buys securities. That gives them more lending money. Once central bank sells the securities, they are put on the balance sheets of the banks and their cash reserves are reduced. The bank has less to borrow now. When a central bank wants expansionary monetary policy, it buys securities. It sells them when it imposes monetary policy that is contractionary.

Reserve Requirement- The criterion for reserve applies to the money banks being kept overnight. Either in their vaults they will hold the reserve or at the central bank. A need for a low reserve helps banks to lend more of their deposits. Because it generates equity it is expansionary. It is contractionary to have a strong reserve requirement. It allows less money to lend to banks. It's particularly difficult for small banks because in the first place they don't have as much to lend. That's why most central banks don't allow small banks to reserve. Central banks rarely change the reserve requirement because changes to their processes are difficult for member banks.

Discount Rate- The 3rd method is the discount rate. It is the amount that central banks charge at their discount window to borrow from their members. Because it is higher than the rate of fed funds, banks use this only if they are unable to raise funds from other banks. There is also a stigma attached to the use of the discount window. The financial world believes that there is difficulty with any bank using the discount window. The discount window would only be used by a desperate bank that has been rejected by others.