Tools of Monetary Policy
A central bank steers the short-term rate with four tools: open market operations, the discount rate it charges banks, reserve requirements, and interest on reserves. Modern frameworks hold the overnight rate inside a corridor whose ceiling is the discount rate and whose floor is the interest paid on reserves.
Why it matters
Banks will not lend overnight below what the central bank pays them on reserves, and they will not pay more than the rate at which they can borrow from the central bank. Those two administered rates fence in the market rate, and open market operations fine-tune where it sits.
Worked examples
The central bank raises the interest rate it pays on reserves. What happens to the overnight market rate?
The floor of the corridor rises, so banks demand at least the new rate to lend overnight. The market rate is pulled up with it, even without any open market operation.
Common mistakes
- ✗Reserve requirements are the main lever today. Open market operations and interest on reserves are primary now, and several central banks have set reserve requirements to zero.
- ✗The discount window is where banks normally fund themselves. It is a backstop, and heavy use can signal that a bank is in trouble.
Revision bullets
- •Four tools: open market operations, discount rate, reserve requirements, interest on reserves
- •A corridor fences in the overnight rate
- •Discount rate is the ceiling, interest on reserves the floor
Quick check
In a corridor system, the floor under the overnight interest rate is set by
Connected topics
Sources
- Mishkin (2018), Ch. 16Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.The tools of monetary policy and the channel/corridor system for the policy rate.