What are the advantages and disadvantages of the three traditional tools of monetary policy?

The advantages and disadvantages of the three major monetary policy tools

The main advantages of the rediscounting operation are that it facilitates the central bank's role as lender of last resort and that it regulates both the total quantity and the structure of the money supply. The main disadvantages of the rediscounting business are that the initiative of the rediscounting business is in the commercial banks, not in the central bank, which limits the initiative of the central bank; the rediscount rate has a limited role in regulating. Increasing the rediscount rate in times of prosperity may not be able to suppress the rediscounting demand of commercial banks because commercial banks are more profitable; lowering the rediscount rate in times of recession may not be able to stimulate the borrowing demand of commercial banks because the level of profitability at this time is even lower. Moreover, the rediscount rate cannot be adjusted frequently, otherwise the frequent fluctuations in market interest rates will cause commercial banks to be at a loss. In addition, the biggest disadvantage of the rediscounting business is that it has a tendency to follow the economic trend; rising prices in times of prosperity make the amount of rediscounted bills rise and the money supply increase; falling prices in times of depression make the amount of rediscounting fall and the money supply decrease. Monetary policy may therefore "add fuel to the fire" in times of prosperity and "add insult to injury" in times of depression.

Open market operations have the following advantages: First, the central bank can use open market operations in a timely manner to buy and sell securities of any size, thus precisely controlling the reserves of the banking system and the base currency to a reasonable level. Although the way it works is basically the same as the rediscount rate policy and the reserve policy, its effect is more accurate than these two policies and is not affected by the degree of response of the banking system. In open market operations, the central bank is always in a proactive position and can conduct monetary policy exactly as it wishes. According to Friedman's intention, the central bank to implement open market operations is "proactive", rather than "passive waiting". Secondly, open market operations do not have a "notice effect" and do not cause misunderstanding of the public's intention of monetary policy, and therefore do not cause unnecessary disruption to the economy. This allows the central bank to conduct open market operations continuously, flexibly, and without time and quantity direction limitations, without causing disruptions in economic operations due to adaptive adjustments by economic agents, and even if the central bank makes a policy mistake, it can make corrections in a timely manner. This is a strong "notice effect" of the rediscount rate policy and reserve policy can not do. Thirdly, the central bank's open market operations do not determine the yields or interest rates of other securities, and therefore do not directly affect the bank's earnings. In addition, open market operations can be used universally and affect socio-economic activities extensively. Accordingly, Friedman insisted that the central bank can use open market operations to completely replace the legal reserve system and rediscount operations.

Open market operations must have the following three conditions in order to play a full and effective role: (1) the central bank must have a strong enough to intervene in and control the entire financial market financial strength; (2) there is a developed, perfect and nationwide financial market, the securities are complete and reach a certain size; (3) there must be other policy tools to cooperate. If there is no deposit reserve system, the money supply cannot be influenced by changing the excess reserves of commercial banks. The biggest shortcoming of the open market business is the lack of these three conditions of the country can not effectively use this policy tool; in addition, it is slow to take effect, because the impact of the purchase and sale of treasury bonds on the money supply and interest rates need a certain amount of time to be slow to other financial markets, affecting the operation of the economy.

Compared with other monetary policy tools, the reserve policy has the following advantages: (1) the central bank has complete autonomy, it is the easiest to implement among the three major monetary policy tools; (2) the change of the deposit reserve ratio has a rapid effect on the money supply, and once it is determined, commercial banks and other financial institutions are required to implement it immediately; (3) the reserve system is the same for all the commercial banks equally and all financial institutions are equally affected.

The shortcomings of the deposit reserve policy are: first, the role is too great, its adjustment of the whole economy and social psychological expectations are too great, not suitable for the central bank as a tool for daily regulation of the money supply, the central bank therefore has a tendency to fix the rate of reserve; second, the effect of its policy is to a large extent affected by the commercial banks of the excess deposit reserves. In the case of commercial banks have a large number of excess reserves, the central bank to raise the legal reserve ratio, commercial banks will be part of the excess reserves for legal reserves, and not contraction of the credit scale, it is difficult to realize the central bank to reduce the purpose of the money supply.