Chapter 15
Tools of Monetary Policy
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The Market for Reserves and the Interbank Rate

The reserves market is where the interbank rate is
determined.

The equilibrium interbank rate is determined at the
point of intersection between the reserves supply and
demand curves.
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How Changes in the Tools Affect the Interbank Rate
1. OMOs:
A purchase of bonds by the central bank increases the
quantity supplied of reserves in the reserves market,
which shifts the reserves supply curve to the right.
Result:
An open market purchase ___ the interbank rate, while
an open market sale causes the interbank rate to ____.
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2. Discount Lending
An increase in discount lending leads to an increase in
the quantity supplied of reserves, which shifts the
reserves supply curve to the right.
Result:
An increase in discount lending causes the interbank
rate to ___, while a decline in discount lending causes
the interbank rate to ____.
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3. Reserve Requirements
A rise in the required reserve ratio increases the
quantity demanded of reserves, which shifts the
reserves demand curve to the right.
Result
A decline in the required reserve ratio causes the
interbank rate to ____, while an increase in the
required reserve ratio causes the interbank rate to __
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Open Market Operations
They are the most important monetary policy tool
because they are the primary determinants of changes
in interest rates and the monetary base, which is the
main source of fluctuations in the money supply.
Types of Open Market Operations
Dynamic OMOs: intended to change the level of
reserves and the MB.
Defensive OMOs: intended to offset movements in other
factors that affect reserves and the MB.
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Advantages of OMOs
1. The central bank can start them and has complete
control over the size of operations and securities
traded.
2. They are flexible and precise.
The central bank can change the level of reserves
and MB by any desired amount.
3. They are easily reversed.
If a mistake is made, it can be immediately reversed.
4. They can be implemented quickly because they
involve no administrative delays.
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Discount Policy
Primarily involves changes in the discount rate.
 It affects the money supply by affecting the volume of
discount loans.
 A rise in discount loans increases reserves, MB, and
money supply, vice versa.

Lender of last Resort:
Discount lending prevents financial panics by providing
banks with reserves when no one else would do so.
Announcement Effect:
Discount lending can be used to signal the central
bank’s intentions about future monetary policy.
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Advantage of Discount Lending
Performing the role of lender of last resort, therefore
strengthening financial institutions.
Disadvantages of Discount Lending
1. Creating confusion about the intentions of the central
bank through the announcement of discount rate
changes.
2. Setting the discount rate at a particular level results
in large fluctuations in the spread between market
interest rates and the discount rate, when market
interest rates change. This leads to fluctuations in
discount loans and money supply.
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Discount Loans and Interest Spread
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Reserve Requirements
They affect money supply by affecting reserves and
the money multiplier.
A rise in reserve requirements:
1) reduces excess reserves and banks’ ability to lend,
2) increases the demand for reserves,
3) increases the interbank rate, and
4) reduces the money supply.
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Advantage of Reserve Requirements
It affects all banks equally and has a powerful effect
on money supply.
Disadvantages of Reserve Requirements
1. Not practical because small changes in required
reserve ratio leads to large changes in money
supply, making mistakes too costly.
2. Raising reserve requirements may cause liquidity
problems for banks with low excess reserves.
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