28.3 How a Central Bank Executes Monetary Policy

Central banks wield powerful tools to steer the economy. They buy and sell securities, adjust reserve requirements, and set discount rates to influence money supply and interest rates. These actions can stimulate growth during recessions or cool down overheating economies.

Banks play a crucial role in this system. Their balance sheets, consisting of assets like loans and liabilities like deposits, determine their lending capacity. By managing reserves and assessing loan risks, banks act as intermediaries between central bank policies and the broader economy.

Central Bank Monetary Policy Tools

Open Market Operations

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• Open market operations involve the central bank buying or selling government securities (Treasury bills, bonds, notes) in the open market to influence money supply and interest rates
• Buying securities injects money into the economy, increases the money supply, and puts downward pressure on interest rates by increasing the supply of loanable funds
• Selling securities removes money from the economy, decreases the money supply, and puts upward pressure on interest rates by decreasing the supply of loanable funds
• Expansionary monetary policy involves buying securities to increase money supply, lower interest rates, and stimulate borrowing and spending (during a recession)
• Contractionary monetary policy involves selling securities to decrease money supply, raise interest rates, and reduce borrowing and spending to combat inflation (during an economic boom)

Reserve Requirements and Discount Rate

• Reserve requirements set the minimum fraction of deposits that banks must hold as reserves (vault cash, deposits at the Fed), limiting the amount they can lend out
• Lowering reserve requirements allows banks to lend more, increasing the money supply and putting downward pressure on interest rates (expansionary policy)
• Raising reserve requirements forces banks to lend less, decreasing the money supply and putting upward pressure on interest rates (contractionary policy)
• The discount rate is the interest rate the Fed charges on loans to banks (discount window lending)
• Lowering the discount rate makes borrowing from the Fed more attractive, increases lending and money supply, and puts downward pressure on other interest rates (expansionary policy)
• Raising the discount rate makes borrowing from the Fed less attractive, decreases lending and money supply, and puts upward pressure on other interest rates (contractionary policy)

Bank Balance Sheets and Lending

Bank Balance Sheets

• Assets include reserves (vault cash, deposits at the Fed), loans (mortgages, business loans, consumer loans), and securities (government bonds, corporate bonds)
• Required reserves $=$ reserve requirement $\times$ deposits, excess reserves $=$ total reserves $-$ required reserves
• Liabilities include deposits (checking accounts, savings accounts, CDs) and borrowings (loans from other banks, the Fed)
• Bank capital is the difference between assets and liabilities, acting as a buffer against losses (loan defaults, investment losses)
• Factors affecting lending include reserve requirements (higher requirements mean less lending capacity), demand for loans (more demand means more loans if excess reserves are available), and perceived risk of loans (riskier loans require higher interest rates or may be denied)