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Which tool of monetary policy is most important? 

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martairobert | (Level 1) Salutatorian

Posted February 17, 2013 at 3:30 AM via web

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Which tool of monetary policy is most important? 

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted February 17, 2013 at 3:52 AM (Answer #1)

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There are three main tools of monetary policy.  These are the required reserve ratio, the setting of interest rates, and open market operations.  Open market operations involve the buying and selling of government equity securities by the central bank (in the US, this is the Federal Reserve).  Of these, open market operations are said to be the most important.

There are four main reasons why this is so.  First, these operations can be done completely at the discretion of the Fed.  It is completely independent in this regard.  Second, open market operations are completely reversible.  If the Fed believes that it has bought too many government securities, it can easily remedy that by simply selling some of those securities.  Third, open market operations are easily fine-tuned.  They can be made in any amount, large or small.  Finally, open market operations can be implemented quickly.   The Fed does not need to wait for these operations to take effect as it would have to when it changes interest rates.  By buying or selling securities, it instantly changes the money supply.

In these ways, open market operations are the most important tool because they are much more flexible than any of the other tools.

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