Question

Describe the monetary policy tools available to the Fed and how they can be used to decrease the money supply

Answer 1

The Federal Reserve has a variety of monetary policy tools it can use in order to implement monetary policy. Fed has three main primarily monetary policy tools:

• open market operations,
• the discount rate
• the reserve requirement.

1. Open Market Operations

Open market operations means the purchase and sale of securities in the open market by a central bank is one of the key tool used by the Federal Reserve in the implementation of monetary policy. Actually, the Fed carries out open market operations only with the nation's largest securities dealers and banks, not with the general public. In the case of an open market purchase of securities by the Fed, it is more realistic for the seller of the securities to receive a check drawn on the Fed itself.Before the global financial crisis, the Federal Reserve used OMOs to adjust the supply of reserve balances so as to keep the federal funds rate.

The money supply decreases when the Fed sells a security. Fed sells government securities to a firm that deals in them.

Fed sells government securities to a firm that deals in them.It takes payment by debiting the account that the dealer’s bank has at the Fed.The bank in turn debits the dealer’s bank.

The banking system has fewer funds to lend.it creates an upward pressure on the federal funds rate. Other interest rates in the economy also rise as a result. It slows the economy and reduces money supply 2. Discount Rate The discount rate is the interest rate Reserve Banks charge commercial banks for short-term loans. Federal Reserve lending at the discount rate complements open market operations in achieving the target federal funds rate and serves as a backup source of liquidity for commercial banks.The Fed is able to affect monetary policy by changing the discount rate. When the Fed wants to decrease the amount of money in the system, it raises the discount rate. This discourages banks from borrowing money at the Discount Window because the cost of borrowing the money is so high. And when banks are not borrowing as much, they don’t have as much to put into the system by lending it out.and hence this reduces money supply. 3. Reserve requirement The reserve requirement refers to the money banks must keep on hand overnight. They can either keep the reserve in their vaults or with the Fed. The Federal Reserve is responsible for setting the reserve requirements for banks. Reserve requirements specify what percentage of a bank’s deposits the bank has to keep on reserve with the Fed. For instance, if the Fed sets the reserve requirement at 10 percent and a bank has $10 billion in deposits, the bank is required to keep $1 billion on reserve at the Fed. The Fed is able to affect monetary policy by changing reserve requirements. When the Fed wants to decrease the amount of money in the system, it raises the reserve requirements for banks. This forces banks to pull money out of circulation and put it into reserve. Hence this reduces their credit giving capacity and lowers the amount of money supply in the market.