The broadest goal of a monetary policy in any nation is to ensure a prosperous economic growth rate, while maintaining a low rate of inflation. Of course, that is a lot easier said than done. But at the end of the monetary policy day, central banks like the U.S. Federal Reserve or the People's Bank of China have four basic tools. The first tool of monetary policy involves the setting of the reserve ratio or the reserve requirement. We have already learned the lower the reserve requirement, a higher the money supply multiplier. And the more money the private banking system will create through the borrowing and lending process. As a practical matter, central banks rarely use changes in the reserve requirement tool to try to stimulate an economy out of recession or contract the economy to control inflation. Instead, the primary function of the reserve requirement is to ensure that banks don't fall below a safe level of reserves and thereby undermine the stability of the system. Here you may recall that the nation's central bank serves as a banker's bank by lending money to private banks when they need such funds. And the rate charged by the central bank is typically called the discount rate. In this key definition, the discount rate is the interest rate that the central bank charges banks when these banks borrow money from the central bank. Of course, by lowering the discount rate, the central bank can expand the money supply because a lower discount rate makes it cheaper for banks to borrow funds. In contrast, raising the discount rate makes such funds more expensive and such a step is likely to contract the money supply. The third and by far the most important instrument of monetary policy is, open market operations. In this key definition, open market operations involve the buying and selling of government securities to expand or contract the money supply. In a nutshell, nation's central bank buys government securities when it wants to expand the money supply and thereby lower interest rates to stimulate economic growth. Inversely, the central bank will sell government securities when it wants to contract the money supply and thereby raise interest rates to contract the economy to control inflation. Now here's the key point, by altering its holdings of government securities, the Fed can change bank reserves and through the money supply multiplier, the Fed can thereby trigger a sequence of events that ultimately determine the total supply of money. A fourth major tool the monetary policy is known as quantitative easing or QE for short. And it was originated by the United States Federal Reserve and the recessionary aftermath of the 2007 financial crisis. Prior to the advent of quantitative easing, central banks like U.S. Federal Reserve or Bank of Japan focused on setting short-run interest rates to implement discretionary monetary policy through the setting of rates like the discount rate. The underlying idea was that, if the central bank lowered short-term interest rates, long-run interest rates on things like mortgages and long-term bonds would follow and have the desired monetary policy effect. The problem the US Federal Reserve encountered in 2007 however, was that the recession was so severe, it had to keep lowering short-term rates almost to zero and the economy still wasn't recovered. At that point, US Federal Reserve decided to institute a program of quantitative easing to attack in the jargon of bond traders, the long end of the bond yield curve, that is longer-term interest rates. Basically, quantitative easing entails buying long-term bonds with newly printed central bank money. It's buying activity drives up long-term bond prices and thereby drives down long-term bond yields which are inversely related to prices. Today, quantitative easing has become an institutionalized part of the tool as a monetary policy used by nations to close recessionary and inflationary gaps. Suppose then, that the US Federal Reserve thinks the economic winds are blowing up a little inflation and suppose further, that at its next Open Market Committee meeting, the Federal Reserve committee votes to contract the money supply drive up interest rates, drive down business investment and the GDP growth equation, and thereby put a damper on the inflationary pressures that are building. So, what should the Open Market Committee do in this case? Buy or sell bonds. Please jot down your answer before moving on. In this case, the Fed will sell bonds. For example, it may unload $1 billion of US Treasury bills on the open market, is to whom these bonds are sold and how it will tighten the money supply and drive up interest rates, here's one variation on how that might work. Fed sells the $1 billion worth of bonds on the open market that includes dealers and government bonds. We then resell them to commercial banks, big corporations, other financial institutions and individual. Hence the term, open market operations. Now in order to buy the bonds, the purchaser writes a check that the Federal Reserve drawn from an account in a commercial bank. For example, if the Fed sells $10,000 worth of bonds to Linda Smith, she writes a check on the coyote bank of Santa Fe, New Mexico. The Fed then presents this check at the Coyote Bank. And, here's the key point. When the Coyote Bank pays the check, reduce its balance of reserves with the Fed and the reserves in the entire commercial banking system by $10,000. Of course, this reduction in reserves will ripple through the rest of the system in the form of reduced lending and thereby a reduced supply of money. In fact, it is precisely this ripple effect that drives monetary policy. And in our next module, we will explore in much more detail as to how the various tools of monetary policy may be used to close recessionary and inflationary gaps. For now however, take a rest. When you're ready, let's move on.
