What Are the Tools of Monetary Policy? – Monetary Policy Tools

Monetary policy is operating economic actions for a drastic growth and investment of a country’s financial and economic policies. Regulated, administered, and monitored by the country’s central bank, a monetary policy is devised and implemented to control the domestic money supply and manage the interest rates and macro-economic objectives directly related to sustainability and overall economic matters. The understanding financial course of action involves employing physical and economic plans of activities and strategies enforced by the central bank, currency board, or any other monitoring authority of a country that is responsible for supervising and normalizing the money quantity in terms of economy and determine channel through which new money is distributed and supplied.

It involves meticulous management and administration of money supply and regulation of interest rates and schemes to control inflation, evaluate growth, and analyze consumption and liquidity. As a result, every country’s monetary policy and outcomes diverge according to the preferences and economic goals set on an annual basis. The economic state then evaluates these policies, investors, analysts, and financial analysts as decisions acquired through altered monetary policies strongly influence the markets’ overall economic pillars and other aspects.

What are the tools of monetary policy?

The monetary policy tools are reserve requirements, interest on reserves, the discount rate, and open market operations. These tools represent actions that a central bank can undertake to control the overall money supply and achieve sustainable economic growth.

The formulation of monetary policy is directly influenced by the exposure of multiple inputs from various sources. Therefore, the inculcation of different dynamics such as GDP, inflation rate, sector-specific growth rates, geopolitical parameters, and international markets such as the tariffs and oil embargo is necessary to analyze monetary policy and its formulation. Including these parameters would also allow the representation from small-scale and large-scale industries and businesses, business organizations, and government and non-governmental organizations.

Monetary policy

The monitoring establishments and authorities are looking for balanced policies and strategies to attain particular objectives on an annual or prolonged period. These authorities must implement situations that would automatically participate in a significant rise of GDP, reduce unemployment percentage, maintain foreign exchange Forex, and regulate inflation rates. For effective employment, scrutinizing strategies and policies can be combined with fiscal policies by the government regarding borrowing and exchange to keep the economy flowing. In the United States, the Federal Reserve Bank is the chief central bank responsible for maintaining and regulating monetary policies. The Federal Reserve Bank aims to reduce employment percentage while keeping track of inflation at the same time. Therefore, it is responsible for maintaining an economic balance between growth and inflation rate. It is also accountable for predicting the long-term interest rates and manage them to prevent them from increasing. Furthermore, it provides banks with liquid cash, evaluates and regulates it to avoid failure in banks and fiasco in financial sectors.

The Fed uses four parameters to analyze, evaluate, and understand monetary policy objectives.

Fed monetary policy tools

When the fed adjusts its interest rate, the four main monetary policy tools are:

  • The discount rate: This is the total interest rate provided by the reserve banks from the commercial banks for the short-term acquisition of loans.
  • Reserve requirements: This factor determines the level of reserves a bank is legally allowed to hold. The banks hold these deposit segments in the shape of cash in their vaults or deposits at the reserve bank. If the reserves are increased, it will significantly reduce the availability of funds in the bank system often lent to consumers and businesses.
  • Open market operations: This is the concept of buying and selling government-oriented bonds with commercial banks. The buying and selling of US government assets and securities are considered reliable in addressing monetary policies. This instrument is directed by FOMC and is regulated and implemented by the federal reserve bank of New York. The Federal Reserve lends to the commercial banks at the discounted rate, which assists and complements the open market operations, helps achieve the target federal funds rate, and acts as a principal source of liquidity. The discount rate is directly linked to the interest rates. Higher rates can impede the process of lending and spending by the customers and even businesses.
  • Interest on reserves: This is a considerably new and updated tool used by the Feds after the financial crisis of 2007 and 2009. Interest on reserves is applied on additional capitals accumulated at the reserve banks. Fed often requires commercial banks to hold a small percentage of their deposits on reserve, and in addition to these allotted reserves, commercial banks are often required to have further funds on reserve. Therefore, implementing interest on the reserve is said to use interest on reserves as a primary tool for monetary policy and shape bank lending.

What is the fed’s most important monetary policy tool?

The most important Fed’s monetary policy tool is the Open market operation.  Buying and selling government-oriented bonds with commercial banks can help Fed to achieve desired target federal funds rate. 

When inflation is the Fed aims to slow the economy, what is a tight money policy?

Tight money policy represents the course of action undertaken by a central bank to slow down overheated economic growth and reduce inflation.  Higher interest rates increase the cost of borrowing, reduce spending and reduce inflation.

Types of monetary policies

Monetary policies can be categorized as expansionary and contractionary. The former refers to the strategies to increase economic expansion and growth by enriching economic activity. To achieve this objective, the central bank or the establishment tends to lower the interest rate through different strategies to encourage the concept of spending and purchase. The latter involves the inculcation of a higher inflation rate and the cost of living and conducting business. As a result, the interest rates are increased, and the growth is significantly slower to bring down inflation. On the other hand, contractionary study measures involve a slow and steady chronic growth and increased rate of unemployment as well as keep the economy regulated.

Monetary policy tools examples:

  • Increase or decrease interest rate charged to commercial banks
  • Fed can increase the reserve requirement, and then the Federal Reserve will take money out of the money supply and increase the cost of credit.
  • Buying and selling government-oriented bonds with commercial banks
  • Fed can pay interest on reserves that allows Fed to place a floor on the federal funds rate.



The effectiveness of monetary policy related to the body is entirely independent of external and internal factors solely responsible for drafting, announcing, and implementing the vital pillars of economic function. These establishments should work independently and without external pressures that include government or political influences. Most central banks and the establishment responsible for implementing monetary policies are well known to receive political and governmental pressure, significantly influencing their decisions.

The credibility and value of Monterrey policies depend on the public credibility. If the policies implemented by the establishments are considered dependable, then the inflation rate is expected to drop and come down quickly. This can only happen if that central authority is independent of decision-making and liberated from political authority. To protect the authority from the potential political pressure, credible policies need to be drafted and implemented by establishments that will help them acquire public confidence.

What are the tools used to implement fiscal policy?

The main tools to implement fiscal policy are taxation (collecting tax on income spending etc. ), spending, and government expenditure.



Igor has been a trader since 2007. Currently, Igor works for several prop trading companies. He is an expert in financial niche, long-term trading, and weekly technical levels. The primary field of Igor's research is the application of machine learning in algorithmic trading. Education: Computer Engineering and Ph.D. in machine learning. Igor regularly publishes trading-related videos on the Fxigor Youtube channel. To contact Igor write on: igor@forex.in.rs

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