Question

1) Name three tools of the Federal Reserve.

2) Explain each tool AND how it's used to keep the market from getting too hot (inflation) our falling into a recession.

Answer 1

1) Federal reserve tools are:

Discount rate

reserve requirement and

open market operations

2)a) Open market operations: This means buying and selling of government securities to public. If the Fed decides to sell the securities, it is reducing the money supply and inflation and if it buys the securities, then it is increasing the money supply and hence increase inflation rate

b) Reserve requirement: It is the amount kept aside by the banks as cash to meet the requirements of the depositors who need money. if the reserve requirement is high, less would be available for loans and hence less money supply , so the inflation would be less.

c) Discount rate: It is the rate at which Fed is charging the commercial banks for funds. If Fed raises interest rate , then there would be contractionary policy and hence money supply would reduce, which would also reduce the inflation rate and vice versa

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