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Erika Rasure is globally-recognized as a leading consumer economics subject matter expert, researcher, and educator. She is a financial therapist and transformational coach, with a special interest in helping women learn how to invest.
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Central banks have four main monetary policy tools: the reserve requirement, open market operations, the discount rate, and interest on reserves. Most central banks also have a lot more tools at their disposal. These additional tools can include forward guidance, inflation targeting, and special lending programs. By utilizing a combination of these methods, central banks aim to influence economic activity and maintain financial stability.
Here are the four primary tools and how they work together to sustain healthy economic growth.
The reserve requirement refers to the money banks must keep on hand overnight. They can either keep the reserve in their vaults or at the central bank. A low reserve requirement allows banks to lend more of their deposits. It's expansionary because it creates credit.
A high reserve requirement is contractionary. It gives banks less money to lend. It's especially hard for small banks because they don't have as much to lend in the first place. That's why most central banks don't impose a reserve requirement on small banks. Central banks rarely change the reserve requirement because it's difficult for member banks to modify their procedures.
Open market operations are when central banks buy or sell securities. These are bought from or sold to the country's private banks. When the central bank buys securities, it adds cash to the banks' reserves. That gives them more money to lend. When the central bank sells the securities, it places them on the banks' balance sheets and reduces its cash holdings. The bank now has less to lend. A central bank buys securities when it wants an expansionary monetary policy. It sells them when it executes tight monetary policy.
The U.S. Federal Reserve uses open market operations to manage the fed funds rate. Here's how the fed funds rate works. If a bank can't meet the reserve requirement, it borrows from another bank that has excess cash. The amount borrowed is called "fed funds." The interest rate it pays is the fed funds rate. The Federal Open Market Committee (FOMC) sets a target for the fed funds rate at its meetings. It uses open market operations to encourage banks to meet the target.
The fed funds rate is the most well-known of the Fed's tools.
Quantitative easing (QE) is open market operations that purchase long-term bonds, which has the effect of lowering long-term interest rates. Before the Great Recession, the Fed maintained between $700 billion to $800 billion of Treasury notes on its balance sheet. It added or subtracted to affect policy, but kept it within that range.
In response to the recession, the Fed lowered the fed funds rate to its lowest level, a range of between 0% and 0.25%. This rate is the benchmark for all short-term interest rates. The Fed then needed to implement QE as a secondary tool, to keep long-term interest rates low. As a result, it increased holdings of Treasury notes and mortgage-backed securities to more than $4 trillion by 2014.
As the economy improved, it allowed these securities to expire, in the hopes of normalizing its balance sheet. When the 2020 recession hit, the Fed quickly restored QE. By May 2020, it increased its holdings to more than $7 trillion. After growing the balance sheet to nearly $9 trillion by 2022, the Fed started to reduce its holdings, down to $7.3 trillion by June 2024.
The discount rate is the rate that central banks charge their member banks to borrow at their discount window. Because it's higher than the fed funds rate, banks only use this if they can't borrow funds from other banks.
Using the discount window also has a stigma attached. The financial community assumes that any bank that uses the discount window is in trouble. Only a desperate bank that's been rejected by others would use the discount window.
The fourth tool was created in response to the 2008 financial crisis. The Federal Reserve, the Bank of England, and the European Central Bank pay interest on any excess reserves held by banks. If the Fed wants banks to lend more, it lowers the rate paid on excess reserves. If it wants banks to lend less, it raises the rate.
Interest on reserves also supports the fed funds rate target. Banks won't lend federal funds for less than the rate they're receiving from the Fed for these reserves.
Central bank tools work by increasing or decreasing total liquidity. That’s the amount of capital available to invest or lend. It's also money and credit that consumers spend. It's technically more than the money supply, known as M1 and M2. The M1 symbol denotes currency and check deposits. M2 is money market funds, CDs, and savings accounts. Therefore, when people say that central bank tools affect the money supply, they are understating the impact.
Many central banks also use inflation targeting. They want consumers to believe prices will rise so that they are more likely to buy now rather than later. The most common inflation target is 2%. It's close enough to zero to avoid the painful effects of galloping inflation but high enough to ward off deflation.
In 2020, the Fed launched the Main Street Lending Program to assist small and medium-sized businesses affected by the COVID-19 pandemic.
Many of the Fed's other tools were created to combat the 2008 financial crisis. These programs provided credit to banks to keep them from closing. The Fed also supported money market funds, credit card markets, and commercial paper.
In response to the 2008 financial crisis, the Federal Reserve began paying interest on excess reserves held by banks. This allows the bank to influence lending trends by reducing rates (encouraging lending) or raising them (discouraging lending). The Bank of England began doing this in 2009. The European Central Bank has done it since 1999.
Most monetary policy tools are always being used, and the strategies are simply adjusted as economic conditions change. There is always some level of reserve requirement, reserves earn interest, and discount rates always apply. One exception is quantitative easing—when the economy is doing well, there isn't a reason for the Federal Reserve to purchase any long-term bonds.
