Tools
Open Market Operations (OMO)
• Buying and selling government securities in the open market.
• Expansionary OMO: Central bank buys securities to inject money into the economy, lowering interest rates.
• Contractionary OMO: Central bank sells securities to withdraw money from the economy, raising interest rates.
Discount Rate
• The interest rate charged by the central bank on loans to commercial banks.
• Lowering the Discount Rate: Makes borrowing cheaper for banks, encouraging lending and investment.
• Raising the Discount Rate: Makes borrowing more expensive, reducing lending and cooling the economy.
Reserve Requirements
• The fraction of deposits that banks must hold in reserve and not lend out.
• Lower Reserve Requirements: Increases the amount of money banks can lend, stimulating the economy.
• Higher Reserve Requirements: Reduces the amount of money available for lending, slowing economic activity.
Types
Expansionary
• Implemented to stimulate economic growth during a recession or period of slow growth.
• Tools: Lowering interest rates, buying government securities (QE), reducing reserve requirements.
• Effects: Increased consumer and business spending, higher investment, lower unemployment.
Contractionary
• Implemented to curb inflation and cool down an overheated economy.
• Tools: Raising interest rates, selling government securities (QT), increasing reserve requirements.
• Effects: Reduced consumer and business spending, lower investment, higher unemployment.
see also: federal reserve system, taper tantrum
Transmission Mechanism
The process by which monetary policy decisions affect the economy includes several channels:
- Interest Rate Channel:
• Changes in central bank policy rates influence short-term and long-term interest rates.
• Affects borrowing costs for consumers and businesses.
- Credit Channel:
• Availability of credit can be influenced by changes in reserve requirements and open market operations.
• Impacts the ability of businesses and consumers to obtain loans.
- Exchange Rate Channel:
• Monetary policy can affect the exchange rate.
• A lower interest rate can depreciate the currency, making exports cheaper and imports more expensive.
- Expectations Channel:
• Central bank policies influence expectations about future economic conditions.
• Expectations can drive consumer and business behavior.