Question

The federal reserve has three major tools that it can use to control money supply growth and interest rates- reserve requirements, discount rate, open market operations. However, the fed relies exclusively on open market operations.

(A) Why doesn’t the fed use its reserve requirement and discount rate power?

(B) Why does the Fed reply so exclusively on open market operations?

Answer 1

Fed can manage the money supply by changing the legal reserve requirement, changing the discount rate, and engaging in open market operations. Reserve requirement is the amount of deposit commercial banks have to keep as reserve and that cannot be lent out. The discount rate is the interest rate banks are charged when they borrow from the Fed which is same as the federal funds rate.

A) The Fed can lower the legal reserve requirement and vice versa, making more/less reserves available for loans. Note, though, that the Fed can increase/decrease reserves available, but it can’t make people borrow/lend. Similarly, the Fed can increase/decrease the discount rate, but banks still have to want to borrow to make this work. Hence these options are not highly effective for Fed to achieve its goal. also it takes time from policy change to take its effect in the economy.

B)Open market operations is the buying and selling of government securities in the open market in order to expand or contract the amount of money in the economy/ banking system. Fed relies exclusively on open market operations because they take effect fast and are very flexible. Buying and selling of securities draws or pours in money in the system fast and hence is highly effective