The central bank (in the United States, the Federal Reserve) can change bank reserves and interest rates. Its tools work through How Banks Create Money and the The Money Market.
Key idea
The classic tools: open market operations (buying or selling government bonds), the discount rate (the rate the Fed charges banks for loans), and reserve requirements. Today the Fed also sets interest on reserve balances (IORB). Buying bonds, cutting the discount rate, lowering reserve requirements and cutting IORB are expansionary; the opposites are contractionary.
Why it works
When the Fed buys a bond from a bank, it pays by adding reserves to the bank's account at the Fed: new money from nowhere, all of it excess reserves, so banks can lend more and interest rates fall. Selling bonds drains reserves and does the reverse. A lower discount rate makes it cheaper for banks to borrow reserves. A lower reserve requirement turns required reserves into excess ones. A lower IORB makes leaving money at the Fed less attractive than lending it, pulling short-term rates down.
| Goal | Open market operations | Discount rate | Reserve requirement | IORB |
|---|---|---|---|---|
| Expansionary (fight recession) | buy bonds | lower | lower | lower |
| Contractionary (fight inflation) | sell bonds | raise | raise | raise |
Worked examples
Worked example: Fighting inflation
Inflation is running well above the Fed's goal. Which open market operation fits, and why?
- It wants higher interest rates and less spending: contractionary policy.
- Sell government bonds: buyers pay with reserves, which leave the banking system, so lending and the money supply shrink.
Answer: Sell bonds
Worked example: How big a change?
With a 10% reserve requirement, the Fed buys \$3 million of bonds from banks. What is the largest possible change in the money supply?
- Excess reserves rise by \$3 million.
- $3{,}000{,}000 \times \dfrac{1}{0.10} = 30{,}000{,}000$ dollars.
Answer: \$30 million
Common mistake
Thinking the central bank buys bonds to fight inflation. Buying bonds adds reserves and money, which is expansionary. Check: the Fed pays for bonds with new reserves, so "buy" means more money.