The Tools of Monetary Policy

The central bank's main lever is the federal funds rate, the rate banks charge each other for overnight loans of reserves. The Fed hits a target for this rate mainly through open market operations: buying or selling government bonds. One rate moves the whole economy because bank reserves are the base that all lending and deposit creation rest on, and the money multiplier spreads any change in reserves into a much larger change in the money supply through the banking system.

Walk through an open market purchase. The Fed buys bonds from a bank, paying with reserves it creates electronically, not printed cash. That bank now holds excess reserves and lends them out; the borrower deposits the money in another bank, which keeps required reserves and lends the rest. This chain repeats, so a reserve injection expands checking deposits by a multiple of itself. That is why the Fed does not print the money supply directly: it only creates the base reserves, and the banking system, through lending, does the multiplying.

The discount rate is the backup tool: the rate the Fed charges banks that borrow reserves directly from it instead of from other banks. Raising it makes borrowing reserves more expensive, so banks hold fewer reserves and lend less, shrinking the money supply, the mirror image of an open market purchase. In the money market graph, an open market purchase shifts money supply right, lowering the nominal interest rate; lower rates cut the cost of borrowing for investment and consumption, shifting aggregate demand right in the AD-AS model.