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Monetary policies are the result of an attempt by the main bank in an economy to control the outcomes of the economy through the use of such policies. Therefore, the instruments of monetary policy include those tools or methods by which the central bank achieves these objectives. The objective of the bank may be to kick start a stalled economy or it may be to slow down an economy that is way too active for any level of sustainability. To this end, the central bank may utilize interest rates, reserves, lending, guidelines and open market operations.
One of the instruments of monetary policy is interest rates, which is a reference to the interest rates that such a bank charges other banks on the money it remits to them. The central bank is able to use the interest rate to achieve its purpose, because any manipulation of the interest rate by the central bank is transmitted by the other banks to the consumers. Assuming the central bank is trying to decrease the rate of consumption in the economy through the application of higher interest rates, the other banks will transfer this burden to consumers who will no longer have easy access to finance for various purchases. It will also cause more consumers to save money due to an increase in the interest that is paid by the banks on the savings deposits. In this manner, the central bank is able to reduce the amount of money that is circulating in the economy.
Another inclusion in the instruments of monetary policy is reserves, in which the central bank may make it mandatory for the other banks to increase or decrease the aggregate reserve they have with the central bank. Usually, banks have a portion of their assets as reserves with the central bank, leaving only a certain fraction for use as liquid cash. When the central bank increases or decreases the percentage of reserve requirement, it will also affect the ease with which consumers can obtain finance from the banks.
Guidelines from the central banks to the other banks is another inclusion in the instruments of monetary policy. Usually, the management of banks have a certain amount of discretion that they normally apply to the running of their financial institutions. The application of guidelines stating the objectives the central bank is trying to achieve and mandating the banks to comply with them removes some of this freedom from the banks.
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