Some of the important poly tools that help in stabilizing monetary conditions in an economy are:

1.1.         Open Market Operations

a.  Through open market operations, the central bank purchases and sells government security from/to commercial banks.

b.  Purchase of securities from the commercial bank increases the reserves with them and acts as an expansionary monetary policy. On the other hand, the sale of securities to commercial banks reduces their reserves and acts as a contractionary monetary policy.

c.  These open market operations are conducted around the target rate or the policy rates.

d.  The central bank, when in need to increase the supply of money in the market, agrees to purchase the government securities and resale the same to the commercial bank after the specified time. All these transactions are conducted at a rate that is usually 25 bps more than the target rate. This also reduces the temporary credit crunch in the hands of commercial banks.

e.  On the other hand, when the central bank wants to decrease the supply of money in the market and there is an excess money supply with the commercial banks; it enters into a repurchase agreement with the commercial banks. Through these agreements, the central bank sells the government securities, to be repurchased after a specified period of time from the commercial banks. These transactions take place at a rate that is usually 25 bps less than the target rates.

1.2.         Policy Rate Changes

a.  The central bank can influence the monetary system in an economy by changing the policy rates, which influences the other rates in the market.

b.  The repurchase rate (repo rate) is the rate at which the central bank agrees to buy or sell bonds to commercial banks through a repurchase agreement.

In most countries,

     i.  the discount rate is the rate at which member banks borrow from the central bank.

    ii.  the federal fund’s rate is the rate of interbank lending on overnight borrowing or reserves.

c.  Raising the policy rates acts as a contractionary monetary policy. This is mainly because the businesses and consumers are less willing to borrow at the raised interest rates.

d.  And, lowering the policy rates can act as an expansionary monetary policy, as it would increase the levels of borrowings.

1.3.         Reserve Requirements

a.  A reserve requirement is a requirement by the central bank that banks keep a specified percentage of their deposits on hand, which thus affects the supply of money.

b.  Increasing the reserve requirements decreases the money supply in the economy and vice-versa.

1.4.         Transmission Mechanisms

a.  The change in policy rates have a direct effect on the:

     i.  market rates,

    ii.  assets prices,

   iii.  expectations and confidence, and

   iv.  exchange rates.

b.  The market rates, asset prices, and consumer’s expectations and confidence affect the domestic demand for goods and services. The consumer’s expectations and confidence and exchange rates, on the other hand, have an impact on the external demand.
The impact on the domestic and external demand is the secondary effect of the price changes.

c.   Thus, the total demand, resulting from domestic and external demand creates inflationary pressures.