What Are Monetary Policy Instruments?

Feb 24, 2021 by

Central banks use instruments such as interest rates to adjust money supply to support an economy. Monetary policies can be executed under different terms and circumstances, but at the end of the day it performs the same role. At the end of the day it is there to properly adjust financial supply (money) into an economy to balance it out.

The essence, concept and objectives of monetary policy

Monetary policy are the actions that are being done by a central bank that overlook the money supply of that specific financial institution. By money supply we mean everything that is related to the flow of funds into the financial institution. That could be cash, checks, credit, as well as money market mutual funds.The most important of these forms is without a doubt credit, because that includes loans, bonds and mortgages.

The essence of monetary policy is to increase liquidity which in return supports economic growth of an economy. Central banks use interest rates, government bonds, and bank reserves to do so. All of the instruments mentioned above directly affect how much a commercial bank can lend out. The volume of loans that can be provided depends directly on the money supply of the institution.

The three main objectives of the monetary policy is :

  • Most importantly, manage inflation.
  • After curbing inflation, reduce unemployment.
  • To promote moderate long-term interest rates.

Each country’s reserve system has specific reasons and goals for its existence. Besides acting as a reserve for the government body, it is also there to overlook stable economic growth on a yearly basis. The number that the system is looking for is 2%-3% per year growth in the country’s gross domestic product.

Expansionary Monetary Policy Tools

Instrument Classification

Central banks tend to classify instruments into the following classifications:

  • By specific spheres of influence. Depending on the situation and the institution’s end goal, you can reduce inflation and increase production.
  • The Structure. There are two types of structure instruments- direct and indirect. The first one being acting through specific rules and regulations, and second one being through market speculation.
  • Parameters- The influence of specific tools directly depends on the number of actions that are done and their quality.
  • The period of an instrument’s influence – As you may have guessed already, short-term instruments help solve small time issues, whilst long-term instruments could potentially last up to a decade!

Everything listed above is needed to directly influence production, pricing, demand and employment.

Instrument Characteristics

All central banks have three general instruments of monetary policy:

  •  All of them operate in the open market. They frequently buy and sell government bonds and other securities from other banks. By doing so the amount of reserves that a financial institution has changes. The bigger the reserve the less a bank can lend and this is known as a banks containment policy.
  •  The second instrument that is used by financial institutions is reserve requirements. This means that central banks inform their employees as to how much money should be kept in reserve each day. Thankfully, not everyone needs all of the cash they have deposited in a bank every day, so banks can lend out most of the cash that is being held with them. This way, banks manage to juggle out the situation and meet most of the loan requests they are dealing with.
  •  The third instrument that is used by financial institutions is a discount rate. This is used to understand how much a central bank charges its client/clients for borrowing from its discount window. A central bank raises the discount rate to discourage other banks from borrowing funds. By doing so, liquidity is reduced and thus slows economic growth. When the discount rate is lowered, that stimulates borrowing. This way liquidity increases and causes accelerated growth.

Most Central banks have many more instruments and they often work together to manage reserves.

Mandatory Reserve Requirements

Before, the requirement was 10%, but starting from March 26, 2020, the required reserve ratio has dropped down to 0%. When a central bank wishes to limit liquidity, it raises reserve requirements. By doing so, this gives banks less funds to lend.When a Central bank wants to increase liquidity, it reduces the needed requirements. Overall, Central banks rarely ever change reserve requirements because it requires a huge amount of paperwork from the person that is requesting the loan.

Foreign Exchange Intervention
Foreign exchange intervention is a type of monetary policy in which a country’s central bank buys or sells its own currency on the foriegn exchange market in order to influence its currency’s value.

Anyone can trade currencies on the foreign exchange and request a fund withdrawal from Finmax. This allows traders to profit from how the value of one currency adjusts in relation to another currency. When a country’s central bank enters the foriegn exchange market and trades its own currency, this process is known as a foriegn exchange intervention.

Open Market Operations
Open market refers to the fact that the reserve system we have mentioned above does not buy securities and bonds directly from a treasury. This way dealers compete in an open market on a price basis by submitting bids/ money offers through an online auction system.

Operating in an open market with a monetary policy ultimately helps the reserve system fulfil double standard mandates- maximize employment and promote price stability by influencing the amount of reserves in the banking system, which in return leads to changes in the interest rates.

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