Question

What methods can be used by the FED to influence interest rates? Are these methods effective? Use examples where appropriate

Answer 1

The Federal reserve primarily uses the following three methods to influence interest rates.

All three methods are equally effective.

1) Changing the discount rate: The discount rate is the rate at which commercial

banks borrow short-term loans from the Federal reserve.

When the Fed (Federal reserve) lowers the discount rate, the commercial banks can

borrow from the Fed at a lower rate. The commercial banks can then lend money to

consumers and businesses at a lower rate. In other words, the Federal reserve indirectly lowers the

interest rates that increases the money supply in the financial system. The Fed does the opposite

to increase interest rates.

2) Changing the reserve requirement: The commercial banks have to deposit a certain portion

of the deposits that they hold with the Federal reserve. This is known as the reserve requirement.

When the Fed wants to lower interest rates, the Fed decreases the reserve requirement. When the Fed

decreases the reserve requirement for commercial banks, commercial banks can lend to customers

at a lower rate leading to an increase in money supply. On the other hand, when the Fed wants to increase

interest rates the Fed increases the reserve requirement.

3) Open market operations: The Federal reserve can influence interest rates by buying and selling treasury securities

in the open market. This is known as open market operations. When the Fed buys government/treasury securities in the open

market that increases the money supply. When there is more money in the financial system, commercial banks lower interest rates.

Therefore, the Fed is indirectly lowering interest rates. On the other hand, when the Fed wants to increase interest rates, the Fed

sells government/treasury securities in the open market.