Lesson 2 of 8 · 14 min
The three tools: open market operations, policy rate, reserve requirements
Central banks change the amount of money and credit by buying or selling bonds, by setting the rate at which they lend to banks, and (less often today) by changing how much of their deposits banks must hold as reserves.
In short
- Open market operations (OMOs): buying government bonds from banks adds reserves and lets broad money grow through the money multiplier; selling bonds does the opposite.
- The policy rate (official, refinancing or target rate) is usually the rate at which the central bank lends to banks, often through short-term repurchase agreements (repos).
- Banks set their base rate (reference rate for customer loans) in line with the policy rate, because they will not lend below what the central bank charges them.
- Examples of policy rates: a two-week repo rate, a refinancing rate, a discount rate; in the US the operational target is the overnight federal funds rate.
- Raising reserve requirements shrinks the money multiplier and is contractionary; it is rarely used in developed markets but still active in many emerging markets.
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