Question

Discuss the methods the Fed uses to enact monetary policy and provide an explanation of the effects these methods have on the supply of money.

Answer 1

There are mainly three methods which are available to FED in order to implement its monetary policy and these tools are given as below:-

The discount rate,

Reserve requirements,

Open market operations

Discount rates:- It can be seen as the interest rate at which FED provides the loans to the other banks for short term. Thus the interest rate at which FED lends money to the other banks is called Discount rates.

Discount rate can be used by the FED in order to control the money supply in the market. When FED wants to regulate the money supply in the market, it will increase the discount rate which will make the loan given to other banks relatively costly and thus these banks will not borrow more money. As there will be less money with the banks, thus they will also restrict giving the money as a loan to the business and common person. Due to this activity, the money supply in the market will be less.

On the other hand, if the money supply has to be improved, then discount rate will be reduced, making borrowing of money from FED relativity cheaper and this extra money can be provided to the common public, thus improving the money supply in the market.

Required Reserve Ratio:- Required Reserve Ratio (RRR) can be seen as the mandatory money which must be deposited by the bank to the FED. This also impacts the money supply in the bank. If RRR is low then lesser money will be deposited with the FED which will avail more money to the bank to lend it to common public and business, thus improving the money supply.

On the other hand, if RRR is increased, the banks have to deposit more money in the FED which will make lesser money available to be provided to business and common public, thereby restricting the money supply in the market.

Open market operations:- This can be seen as when FED buys and sells government securities in the open market. When FED wants to regulate the money supply in the market, it sells the government securities in the open market and excess money is brought to FED reducing the money in the open market. If FED wants to improve the money supply in the market, it starts buying government securities from the open market and thus increasing the flow of money in the market.