Editorial Economics

What Are The Tools Of Monetary Policy ?|Explained

Tools Of Monetary Policy
Written by Peace

The Tools of Monetary policy help to encourage a high level of economic activity, which is what the nation’s central bank needs.

It is only regular for every country to want its economic value to be stable and substantial.

In this article, we will enlighten you on monetary policy tools. Monetary policy stabilizes a country’s economy and promotes additional transparency.

Tools Of Monetary Policy

The main goal is to maintain the nation’s economic value and keep the economy stable, either too high or too low.

It all boils down to the disposal of the nation’s wealth. The central bank is basically in charge of all monetary aspects of the country.

If there is an increase or decrease in the rate charges for loans they give out to other banks, it automatically affects the customers, including big business owners, as they will also add or decrease their rates. 

The tools of monetary policy are four  in number, and they include the following:

1. Reserve Requirement

This is simply the money banks will have to keep in their possession overnight. It is more like a reserve.

It can be controlled either in the central bank or in the vault. It is not befitting for the central bank to have a low budget because they end up lending to other banks from their deposits, which creates debit.

On the other hand, a high reserve requirement is of disadvantage to some small banks because they do not have enough to give out, so sometimes central banks do not impose any reserve requirements on small banks because it will be difficult for them to meet the standard.

Reserve requirements should be able to fulfill specific needs and should serve for emergency withdrawal to avoid cases of borrowing from other nations.

Currently, reserve requirements are set at zero due to the response to the covid19 pandemic. 

Banks give out loans to their customers due to the money or cash they have at hand, but on no account should these banks give out the reserve requirements for loans just in case of emergencies.

This reserve requirement can serve to control liquidation in the economy’s financial sector. 

By reducing the savings requirement, the Fed implements a monetary policy to increase, and conversely, when it raises a condition, it adopts a monetary policy. As a result, this latest action reduces costs and causes economic recovery.

Reserve Requirement History

This practice started in the 19th century with the early and first commercial banks. Each bank has its note used only in the area where it operates.

Transferring it to another currency was expensive and risky because of another bank’s lack of financial information.

To get rid of this problem, some banks settled for voluntary redemption at each branch, agreeing that the issuing bank maintained a gold deposit or something worth or equivalent to gold.

In addition, they ensured that other banknotes were replaced as a medium of exchange. 

The creation of the reserve requirements has, in turn, reduced the risk of nations’ bankruptcy.  

2. Open Market Operations

This refers to buying and selling U.S Treasury securities and other securities in a bid to control or regulate the supply of money in the reserve.

They purchase these treasuries to add up to the collection of money and, at the same time, sell them to reduce long-term interest rates. The goal is to put in check and balance the interest rate. 

Commercial banks must keep a deposit equal to a certain percentage of their pledge in a Federal Reserve bank account.

Any money in their palace that exceeds the required level is available for lending to other banks that may have a deficit.

The interest rate that a bank loan can repay on these loans is called the fed funds rate. Banks often base their interest rates on consumer or business loans at the level of government finances.

3. Discount Rate

This refers to the interest rate that every commercial bank, including other financial institutions, pays for short-term loans they collect from the reserve requirements. This interest determines the value of cash flows.

The claim can also serve for emergency withdrawal. 

Commercial banks in the U.S. have two main ways of borrowing money for their temporary working needs.

First, they can borrow and lend money to other banks without the need for any collateral using the interbank rate driven by the market.

They can also borrow money for their temporary working needs from the Federal Reserve Bank.

Twelve regional Federal agencies are processing the Federal Reserve loan. Financial institutions use loans to cover any shortfall, cover any liquidity problems, or in the worst-case scenario, prevent bank failure.

This lending facility offered by the Fed is known as a discount window.

4. Interest In Excess Reserve

Interest in excess reserved is funds reserved held by a financial institution in excess of what is supposed to be required by regulators.

You can say that excess reserve is a safety buffer. It gives financial firms extra safety in the possible event of loan loss or cash withdrawal made by customers.

As a result, the security of banks is increased, especially when the country’s economy is unstable.

In addition, this excess reserve can cover up losses and stop any form of debt that a nation may likely fall into.

How The Tools Work 

Tools of monetary policy work by increasing and decreasing liquidity that will occur. They control the amount of money available to invest or lend.

As a result, consumers get loans, and some may even lavish on the loans banks give them.

This can, in turn, affect the nation’s economy by placing them in debt, but the monetary tools help to control that through the reserve requirements. 


Some of the monetary tools were created to reduce the financial crisis because, of course, it should be expected at any time, which is why we wrote this article to enlighten you on the tools of monetary policy.

If we are enlightened, we can also know how to assist in making the economy of the nation stable. 

I hope this article serves informative. Do well to drop your comments and questions below in the comment section, and we will be glad to attend to them. 

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