Monetary tools: what they are and how they function

The Federal Reserve creates or extinguishes reserves as central bank liabilities by using open market operations to add or subtract assets from its balance sheet — a tool it began to use to implement countercyclical policy in the 1920s. Abandonment of reserve requirements as a key policy tool was largely due to the expansion of the unregulated offshore markets but also due to banks’ strategies to evade reserve requirements in the home market. Other tools critical to policy implementation include discount window operations that served as the channel for the Fed to act as lender of last resort in supplying emergency liquidity in the 1930s, open market operations to maintain the policy rate at the desired level, and macroprudential tools such as capital and liquidity requirements, limits on leverage, loan loss reserves, loan-to-value ratios, and similar constraints.