What are the tools of monetary policy and how do they impact the market?

Central banks use various tools to implement monetary policies. The widely utilized policy tools include:

Interest rate adjustment

A central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease.

Change reserve requirements

Central banks usually set up the minimum amount of reserves that must be held by a commercial bank. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients and thus, money supply decreases.

Open market operations

The central bank can either purchase or sell securities issued by the government to affect the money supply. For example, central banks can purchase government bonds. As a result, banks will obtain more money to increase the lending and money supply in the economy.

Impact:

Monetary policy impacts the money supply in a market, which influences interest rates and the inflation rate. It also impacts business expansion, net exports, employment, the cost of debt and the relative cost of consumption versus saving— all of which directly or indirectly impact aggregate demand.