Question

List and Explain the three tools the Fed has at its disposal to change the money supply and therefore change interest rates.

Answer 1

• The three tools of monetary policy used by Fed to change the money supply and the interest rates are :-

1. Open market operations :-

• Open market operations are the most frequently used tool by the Fed to conduct monetary policy.
• The Fed purchases government securities from the open markets to increase the money supply. This will eventually lead to an increase in the inflation and decreases the interest rate.
• The Fed sells government securities to the open markets to decrease the money supply. This will eventually lead to a fall in the inflation and hence Increase the interest rate within the economy.

2. Discount rate :-

• Discount rate is the interest rate that is set and charged by the Fed to the banks and other depository institutions for the overnight loans they provide to the banks when they are short of reserves.
• When the discount rate or the interest rate falls, the reserve's in the banks rise and hence the money supply expands within the economy.
• Similarly when the discount rate or the interest rate charged by the Fed rises, the reserve's in the banks fall and hence the money supply contracts within the economy.

3. Reserve requirement :-

• Reserve requirement refers to the amount of deposits the banks are required to keep as reserve's without lending them out to the consumer's.
• When the Fed raises the reserve requirement, the Banks are required to hold a major amount of deposits as reserve's. This decreases their lendings to consumers. This will lead to a fall in the money supply and Increase the interest rates.
• When the Fed lowers the reserve requirement, the Banks are allowed to hold only a small portion of deposits as reserve's and lend out more to consumers. This will lead to a rise in the nation's money supply and hence decrease the interest rates.