28.3 How a Central Bank Executes Monetary Policy

Central Bank Monetary Policy Tools

Central banks use a specific set of tools to control the money supply and influence interest rates across the economy. Understanding how these tools work matters because they're the primary mechanism connecting government policy decisions to the interest rates, borrowing, and spending that affect everyday economic activity.

Open Market Operations

Open market operations (OMOs) are the most frequently used monetary policy tool. The central bank buys or sells government securities (Treasury bills, bonds, notes) on the open market to adjust the money supply.

How buying securities works (expansionary policy):

1. The central bank purchases government securities from banks or the public.
2. It pays for those securities by crediting the sellers' bank accounts, which adds new money to the banking system.
3. With more reserves, banks can lend more, increasing the supply of loanable funds.
4. Greater supply of loanable funds pushes interest rates down.
5. Lower interest rates encourage borrowing and spending, stimulating economic growth.

How selling securities works (contractionary policy):

1. The central bank sells government securities to banks or the public.
2. Buyers pay for those securities, and that money flows out of the banking system and into the central bank.
3. With fewer reserves, banks have less capacity to lend, decreasing the supply of loanable funds.
4. Reduced supply of loanable funds pushes interest rates up.
5. Higher interest rates discourage borrowing and spending, which helps cool inflation.

Reserve Requirements and Discount Rate

Beyond open market operations, central banks have two other key tools: reserve requirements and the discount rate.

Reserve requirements set the minimum fraction of deposits that banks must hold as reserves (either as vault cash or deposits at the Fed). Banks cannot lend out this portion. Changing the reserve requirement directly affects how much money banks can create through lending.

• Lowering reserve requirements frees up more deposits for lending, which increases the money supply and puts downward pressure on interest rates (expansionary).
• Raising reserve requirements forces banks to hold back more, which decreases lending, shrinks the money supply, and puts upward pressure on interest rates (contractionary).

The discount rate is the interest rate the Fed charges when it lends directly to banks through the "discount window."

• Lowering the discount rate makes it cheaper for banks to borrow from the Fed. Banks can then lend more to customers, increasing the money supply and pushing other interest rates down (expansionary).
• Raising the discount rate makes borrowing from the Fed more expensive. Banks borrow less, lend less, and interest rates across the economy tend to rise (contractionary).

In practice, open market operations are the tool central banks rely on most. Reserve requirement changes are rare because they create large, abrupt shifts in lending capacity. The discount rate mainly serves as a signal and a backstop for banks that need short-term funds.

Bank Balance Sheets and Lending

Banks are the intermediaries between central bank policy and the broader economy. To understand why monetary policy tools work, you need to understand how a bank's balance sheet determines its lending capacity.

Bank Balance Sheets

A bank's balance sheet follows the fundamental accounting equation:

$\text{Assets} = \text{Liabilities} + \text{Bank Capital}$

Assets (what the bank owns or is owed):

• Reserves: vault cash plus deposits held at the Fed
• Loans: mortgages, business loans, consumer loans
• Securities: government bonds, corporate bonds

Liabilities (what the bank owes):

• Deposits: checking accounts, savings accounts, CDs
• Borrowings: loans from other banks or from the Fed

Bank capital is the difference between total assets and total liabilities. It acts as a buffer against losses from loan defaults or bad investments. If a bank's capital drops too low, it becomes insolvent.

How Reserves Determine Lending

Two formulas connect reserves to lending capacity:

$\text{Required Reserves} = \text{Reserve Requirement} \times \text{Deposits}$

$\text{Excess Reserves} = \text{Total Reserves} - \text{Required Reserves}$

Excess reserves are what banks have available to lend. For example, if a bank holds $500{,}000$ in total reserves and the reserve requirement on its $4{,}000{,}000$ in deposits is 10%, then required reserves are $400{,}000$ and excess reserves are $100{,}000$. That $100{,}000$ is the bank's immediate lending capacity.

Three main factors affect how much a bank actually lends:

• Reserve requirements: Higher requirements shrink excess reserves, leaving less room to lend.
• Loan demand: Even with excess reserves available, banks only lend if creditworthy borrowers are asking for loans.
• Perceived risk: Riskier borrowers get charged higher interest rates or may be denied entirely. During uncertain economic times, banks may choose to hold excess reserves rather than take on risky loans.

This is why monetary policy doesn't always produce instant results. The central bank can increase reserves, but banks still decide whether and to whom they lend.