Question

How does the Fed now try to influence the money supply? Compare and contrast to the pre-Crisis instruments used. Why does this situation present many unknowns for the success of future policy?

Answer 1

When the Fedral Reserve was established in 1913, it was not to pusue any active monetary policy to stablize the economy. Instead, the founders viewed the Fed as a way to prevent the supply of money and credit from drying up during the economic contractions, which happened often in the pre-1914 period. One of the principal ways in which the Fed was to provide such insurance against financial panics was to act as the lender of last resort. That is, when risky business prospects made comercial banks hesitant to extend new loans, Fed would lend money to the banks thus including banks to lend more money to their customers.

The function of this central bank has grown and today the Fed primarily manages the growth of bank reserves and money supply to allow a stable expansion of the economy. The Fed uses three main tools to accomplish these goals:

1) A change in Reserve requirments.

2) A change in the discount rate.

3) Open market operation.

If the Fed buys back issued securities (such as Treasury Bills) from large banks and securities dealers, it increases the money supply in the hands of the public. Conversely, the money supply decreases when the Fed sells a security. Through this process money supply increases.