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The three main tools of monetary policy are open market operations, reserve requirements, and interest rates. Let us define monetary policy and then look at each tool briefly.
Monetary policy is one of the major ways in which governments try to affect their national economies. Monetary policy seeks to affect the economy through controlling the supply of money. In the United States, monetary policy is set and carried out by the Federal Reserve.
When the economy is in a recession or is not growing quickly enough, the Fed tries to increase the supply of money. It can do this in three ways.
Lowering reserve requirements. This allows banks to loan more money, thus increasing the supply of money available. This tool is not used very much.
Lowering interest rates. When interest rates are lower, people and companies will be likely to borrow more money. This is because a lower interest rate means that it is cheaper to borrow. More borrowing means more economic activity.
Buying government securities in “open market operations.” When the Fed buys government securities from banks, it is giving the banks money that did not previously exist. By doing so, it increases the amount of money in the economy.
When an economy is growing too fast and inflation is a danger, the Fed can do the opposite of the three things mentioned here. It can raise reserve requirements, raise interest rates, and sell government securities.
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