Monetary policy tools and the transmission mechanism

What tools does a central bank use?

Memorize

There are three, and each works by changing how much liquidity banks have or what it costs them. The monetary transmission mechanism , covered below, then carries the effect to the wider economy.

Toolseach changes bank liquidity or the cost of it

• Open market operations Memorize buy or sell government bonds with banks
  • Buy bonds reserves up, lending capacity up (easing)
  • Sell bonds reserves down, lending capacity down (tightening)
• Policy rate Memorize rate at which the central bank lends to banks
  • Repo rate bonds bought with an agreement to sell back; overnight to two weeks
  • Refinancing rate the name some central banks give the policy rate
  • Federal funds rate Know the idea US target for overnight interbank lending of reserves
• Reserve requirement Memorize share of deposits banks must hold as reserves
  • Raise it less lending (tightening); disruptive, rarely changed in developed markets
  • Lower it more lending (easing)

Tool	How it works	To tighten
Open market operations	the central bank buys or sells government bonds with banks; buying adds reserves, so banks can lend more	sell bonds (drain reserves)
Policy rate	the rate at which the central bank lends to banks, often through repos; banks set their base rates off it	raise it
Reserve requirement	the share of deposits banks must hold as reserves; a lower requirement means more lending	raise it (disruptive, so rarely used in developed markets, still used in many emerging ones)

Take each in turn.

Open market operations are purchases and sales of government bonds, usually with commercial banks or designated market makers. When the central bank buys, it pays with new reserves, so banks can lend more and broad money grows through the money multiplier. When it sells, banks pay out reserves and lending capacity shrinks.

The policy rate is the rate the central bank announces and is willing to lend to banks at. The name differs by country. It is often implemented through a repurchase agreement (repo): the central bank buys bonds from banks and agrees to sell them back later, usually from overnight to two weeks. That is a secured loan to the banks, and the central bank earns the repo rate. Two names to know: the refinancing rate is how some central banks label their policy rate (the Bank of England uses the two-week repo rate), and the federal funds rate is the US interbank rate on overnight lending of reserves, which the Federal Open Market Committee steers to a target by adding or draining reserves.

The reserve requirement is the fraction of deposits a bank must hold in reserve. A higher requirement limits money creation. Changing it often is disruptive: a bank short of reserves may have to stop lending until it has rebuilt them. Some central banks no longer set minimum requirements at all, while many emerging markets still use them actively.

Why banks follow the policy rate

Banks do not want to lend at a rate below what the central bank charges them. The central bank can create a cash shortage through open market operations, which forces banks to borrow from it at the policy rate. So when the policy rate moves, each bank’s base rate (the reference rate for all of its customer lending) moves with it, and customers pay base plus a spread that depends on their credit quality.

$$L = P + s$$

Here $L$ is the customer’s loan rate, $P$ the bank’s base rate (equal to the policy rate in the exam’s simplification) and $s$ the customer’s spread.

Exam tip When the policy rate moves, redo the sum from the new base. The exam’s distractor is the old base plus the spread.

How does a rate change reach inflation?

Memorize

A policy rate is usually an overnight or two-week rate, yet firms and households borrow over years. The transmission mechanism explains how the short rate still moves the real economy. It also rests on the idea that money is not neutral in the short run: central banks believe changes in money and credit can move real growth for a while, even if they only move prices in the long run.

A rate rise works through four interconnected channels.

Policy rate risesa cut runs every step in reverse

• Four linked channels Memorize
  • Market rates bank and interbank rates rise; borrowing falls
  • Asset prices bonds, shares and projects fall; wealth falls
  • Expectations slower growth and more hikes expected; spending cut
  • Exchange rate currency tends to appreciate; exports dearer, imports cheaper
• Demand and prices
  • Domestic demand falls
  • Net external demand falls
  • Import prices fall
• Result
  • Inflation pressure eases with a lag and some uncertainty

1. Market rates. Base rates and interbank rates rise. Borrowing becomes dearer for firms and households over short and long horizons, so they borrow less.
2. Asset prices. A higher discount rate lowers the value of bonds, shares and capital projects. Household financial wealth falls, so consumption growth slows.
3. Expectations. If a hike is expected to be followed by more, firms and households expect slower growth and cut spending, borrowing and investment today.
4. Exchange rate. Higher rates tend to make the currency appreciate. Exports become dearer for foreign buyers and imports cheaper at home.

Together these cut domestic demand and net external demand (exports minus imports), and the cheaper imports lower import prices. All of it takes pressure off inflation. A rate cut runs the same chain in reverse.

The channels overlap and feed into each other. A fall in share prices (channel 2) alters expectations (channel 3), and a stronger currency (channel 4) hits exporters’ profits. Treat them as one connected web rather than four separate roads.

The key relationships to hold on to are in one place:

Policy rate rises	Effect
Growth	slows (less borrowing, less spending)
Inflation	falls, with a lag
Short-term market rates	rise
Domestic currency	tends to appreciate

Go deeper Why lower reserve requirements allow more lending

Know the idea

A bank must keep a fraction of each deposit in reserve and can lend the rest. The loan becomes someone else’s deposit, which is again partly lent out, and so on. The lower the reserve fraction, the more rounds of lending are possible and the larger the money multiplier. Raising the requirement shrinks it, which is why the tool is powerful but blunt.

Go deeper Effects are slow and uncertain

Know the idea

How strongly each channel works can change over time. Expectations might not move, long-term rates might not follow the short rate, and the currency may respond to other forces. Central banks therefore treat the mechanism as a guide with lags, not a mechanical lever. The next lessons show where it can break down.