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A bank is an establishment authorized by a government to accept deposits, pays interest, clear checks, make loans, act as intermediary in financial transaction, and provide other financial services to its customers.

If a nation’s economy were a human body, then its heart would be the central bank. And just as the heart works to pump life-giving blood throughout the body, the central bank pumps money into the economy to keep it healthy and growing. Sometimes economies need less money, and sometimes they need more.

A central bank is an entity responsible for overseeing the monetary system and policy of a nation or group of nations, regulating its money supply and interest rates. Central banks have three main monetary policy tools: open market operations, the discount rate, and the reserve requirement. Most central banks also have a lot more tools at their disposal. Here are the three primary tools and how they work together to sustain healthy economic growth.

Open Market Operations

Open market operations are when central banks buy or sell securities. These are bought from or sold to the country’s private banks. When the central bank buys securities, it adds cash to the banks’ reserves. That gives them more money to lend. When the central bank sells the securities, it places them on the banks’ balance sheets and reduces its cash holdings. The bank now has less to lend. A central bank buys securities when it wants expansionary monetary policy. It sells them when it executes contractible monetary policy.

 Reserve Requirement

The reserve requirement refers to the money banks must keep on hand overnight. They can either keep the reserve in their vaults or at the central bank. A low reserve requirement allows banks to lend more of their deposits. It’s expansionary because it creates credit. A high reserve requirement is contractionary. It gives banks less money to loan. It’s especially hard for small banks since they don’t have as much to lend in the first place. That’s why most central banks don’t impose a reserve requirement on small banks. Central banks rarely change the reserve requirement because it’s expensive and disruptive for member banks to modify their procedures.

Discount Rate

The discount rate is the third tool. It’s the rate that central banks charge its members to borrow at its discount window. Since the rate is high, banks only use this if they can’t borrow funds from other banks. There is also a stigma attached. The financial community assumes that any bank that uses the discount window is in trouble.

Only a desperate bank that’s been rejected by others would use the discount window. Central banks are more likely to adjust the targeted lending rate. It achieves the same result as changing the reserve requirement with less disruption. The fed funds rate is perhaps the most well-known of these tools. Here’s how it works. If a bank can’t meet the reserve requirement, it borrows from another bank that has excess cash. The interest rate it pays is the fed funds rate. The amount it borrows is called the fed funds. The Federal Open Market Committee sets a target for the fed funds rate at its meetings.

Featured image source: Business Today

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This article was first published on 24th June 2019


Foluke Akinmoladun is the Managing Solicitor of Trizon Law Chambers. She has been a legal practitioner for 13 years and has experience in a wide range of commercial matters. She is a certified mediator, a member of the Chartered Institute of Arbitrators(UK), holds an Advanced Diploma in Accounting from the Association of Chartered Certified Accountants (UK) and is also a tax consultant. She is a dispute resolution expert, handling commercial disputes from negotiations all the way to litigation (if need be).

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