Question

Explain the tools of the Federal Reserve Bank for the exercise of Monetary Policy.

Reference: 11th edition Financial Markets and Institutions by Jeff Madura, Chapters 4 and 5

Answer 1

Federal Reserve Bank uses the following tools for the exercise of monetary policy:-

1) Reserve Ratio- The reserve ratio is percentage of total deposits which a bank is required to hold as reserves. Change in reserve ratio has a very powerful impact on the money supply but it is seldom used. When Fed want to increase the money supply, it decreases the reserve ratio. This increases the credit creation power of banks and thus leads to increase in the money supply. And if Fed want to decrease the money supply, it increases reserve ratio to decrease the credit creation power of banks and hence reduce money supply in the economy.

2) Open Market Operations- Fed can change the supply of money by buying or selling bonds in the bond market. If it wants to increase the amount of money supply in the economy, it buys bonds and pays for them by creating money and if it wants to decrease the amount of money in the economy, it sells bonds, and it removes from circulation the money it receives in exchange for the bonds. These actions are known as Open Market Operations.

3) Discount Rate- The discount rate is the interest rate which the central bank charges commercial banks that need to borrow additional reserves. If Fed wants to encourage spending and increase money supply, it lowers the discount rate and vice-versa.