Three instruments of monetary policy

Three instruments of monetary policy

As mentioned earlier, the central bank does not control the money
supply directly but it does so indirectly by changing the monetary
base or the reserve-deposit ratio.
To achieve either of these, the central bank can use the following
monetary tools, open market operations, the reserve requirement
and the discount rate.


Open Market Operations
This refers to the buying and selling of government bonds by the
central bank.

General summary: When the central bank conducts open market
purchase, it increases the H and therefore M. When the central bank
conducts open market sales, it reduces H and the money supply.


Discount rate

A bank that is short of reserves can borrow either from the central
bank or from other banks to make good its deficiency. The cost
of borrowing from the central bank is the discount rate. When banks borrow from the central bank, their reserves increase, allowing them to make more loans and therefore create more money

Reserve requirements

An increase in the reserve requirement forces banks to hold more
money multiplier and therefore reduces the money supply for any
level of the monetary base. Vice versa.