14. MONETARY POLICY TOOLS
This chapter introduces the Federal Reserve’s three significant tools for conducting
monetary policy: open-market operations, discount policy, and reserve requirements.
Furthermore, the Fed uses monetary policy to influence the important macroeconomic variables
in society including the GDP growth rate and indirectly the unemployment rate, interest rates,
currency exchange rates, and asset prices such as stock and bonds. Thus, many people,
especially in the financial markets scrutinize the Fed’s actions to determine monetary policy.
Accurately predicting the Fed’s actions, financial companies can reap large profits.
Unfortunately, a central bank using monetary policy may create more instability for an economy
because of time lags, so we discuss several problems of monetary policy.
Open-Market Operations
The Fed can use expansionary or contractionary monetary policies. Expansionary
monetary policy is the Federal Reserve expands the money supply and indirectly reduces the
short-term interest rates while contractionary monetary policy is the Federal Reserve contracts
the money supply that raises short-term interest rates. Moreover, the Fed can use Open-Market
Operations, Discount Policy, and Reserve Requirements to implement a monetary policy. Open-
Market Operations are the Fed’s purchase and sale of U.S. government securities, and its most
important tool. Open-market operations have the same effect if the Fed purchased any short-
term, liquid securities. However, the Fed usually buys and sells U.S. government securities. We
also discuss Discount Policy and Reserve Requirements in their sections in this chapter.
The Fed, for example, wants to expand the money supply by using expansionary monetary
policy. In the T-bill market as represented in Figure 1, the original market price and quantity for
T-bills are P and Q. Then the Fed buys T-bills, creating a greater demand for T-bills, shifting
the demand function rightward. The Fed pays for the T-bills using a “Fed check.” After the
seller deposits the check at his bank, then his or her bank's reserves increase, boosting the
money supply as banks grant loans to borrowers. Consequently, both the market price and
quantity of T-bills rises. Then the market interest rate falls for T-bills, when we calculate it
using the present value formula.
Noticing one thing, open-market operations affect the interest rates because the T-bill is a
short-term credit instrument. When the Fed purchases the T-bills, the T-bill's price rises while
the T-bill interest rate falls. Consequently, the decrease in the short-term interest rates spreads to
other markets, including the federal funds rate, commercial paper, and banker’s acceptances.
Therefore, short-term interest rates on all short-term credit instruments will rise and fall
together.
Contractionary monetary policy works similarly to expansionary monetary policy. Figure 2
depicts market price and quantity for T-bills as P and Q. The Fed sells T-bills, increasing the
supply of T-bills and shifting the supply curve for T-bills rightward. Consequently, the market
price of T-bills falls while the market interest rate for T-bills rises by using the present value