Chapter 16: Monetary Policy Tools
There are three primary tools a central bank can use to influence the money supply:
- Reserve Requirement - Banks are required to keep a certain amount in reserves to return deposits. Increasing this requirement decreases the money in circulation, decreasing it releases reserves into circulation.
- Discount Loans - Releases money to banks at a low interest rate, enabling them to extend more loans, this increasing the money supply.
- Open-Market Operations - Buying or selling securities to adjust its own reserves, increasing its cash by issuing payables or decreasing cash by repurchasing or retiring them.
All of these tools "influence" the money supply but do not constitute precise control: just because the fed decreases reserves does not mean banks will extend more loans (they can, but are not required to reduce their reserves), and just because it offers loans/payables doesn't mean anyone will want to borrow the money or buy their securities. These actions tend to have the desired result, but it is never a certainty.
In most instances, the fed acts as an intermediary between banks. A bank that has reserves in excess of the minimum but cannot issue loans can deposit this amount into the fed, who can then lend it out to another bank whose customers demand more loans than the capital it has to lend. This can happen "overnight" through the federal reserve's funds market. Generally, the fed only needs to take action if the market for funds between banks does not balance out, creating a shortage of supply or demand that would normally affect interest rate if the fed did not cover the balance from its own reserves. This creates stability.
But the fed can also create instability, controlling the inflation rate, by deciding exactly how much of the shortage it wishes to cover - it can raise the interest rate by leaving some demand unfulfilled or lower it by leaving some supply uninvested. In general, the goal is to maintain a stable market for the sake of domestic trade, but adjusting the value of the dollar can be beneficial to adjusting the balance of foreign trade.
Open Market Operations and the Discount Window
Because the central bank is in control of the nation's money supply, it is in constant contact with the primary players - the major banks, brokerages who have money market funds, and various branches of government. The information it gets about their operations, present and future, gives the federal reserve a keen insight of the supply and demand of money in general and the ability to accurately predict changes in the marketplace - so even though its tools are imprecise, it is generally able to use them effectively.
There's mention of the "discount window," an exchange in which banks borrow from the fed's district banks, which is primarily a backup facility that is used when the fund market is not functioning effectively: the reserve itself is offering funds at a rate that is too high to suit the banks, so they seek to obtain these funds at a discount. While the federal reserve functions as the lender of last resort and must discount funds to make them available in times of crisis, it is slow to change its rates, so the discount window is most active when there is a disturbance in the market that has not yet been recognized as a crisis, or when the fed itself is slow to react to the crisis. Dealings at the discount window can be a harbinger of changes in the federal rate, or they may be a temporary condition that subsides of its own accord.
The author also lists a handful of "facilities" that the fed has created on a temporary basis to react to aberrations in the market before taking broader action:
- Term Auction Facility - Enabled depository institutions to bid for short-term funds in an auction format
- Primary Dealer Credit Facility - Provided overnight loans at the discount rate to be settled the following day in order to facilitate after-hours transactions
- Term Securities Lending Facility - Exchanged treasury-backed securities for riskier short-term securities (generally for periods of 28 days)
- Asset-Backed Commercial Paper - Provided money to firms who provide money-market mutual funds so that they could redeem shares without selling their assets into a distressed market
- Commercial Paper Funding Facility - Provided a vehicle by which the federal reserve could purchase short-term bonds issued by nonfinancial corporations
- Money Market Investor Funding Facility - Described only as "another lending program designed to help money markets return to normal."
These "facilities" are instituted as temporary programs that are to be phased out when credit conditions return to normal - but as in all things government, they may be perpetuated indefinitely at a whim.
The Monetary Policy Tools of Other Central Banks
Each central bank governs its own operations, though many of them are similar to the practices of the US Federal Reserve. The author provides a few examples of unusual policy tools used by other central banks. (EN: I'm not taking notes on these because the descriptions become rather abstract and mathematical, and they are "unusual practices" that are curiosities, but likely irrelevant unless they become adopted by the US central bank.)