Question

In your own words; explain the three main monetary policy tools the Fed uses to try to prevent inflation and recession.

Answer 1

The Federal Reserve’s three instruments of monetary policy are open market operations, the discount rate and reserve requirements.

Open-market operations include the acquisition and selling of government securities. The word "free market" means that the Fed will not decide by itself with which bond dealers it will be doing business on a given day. Rather, the option comes from a "free market" in which the Fed 's numerous bond dealers – the main dealers – compete on a price-based basis. Open market operations are versatile, and therefore the most widely used monetary policy device.

The discount rate is the interest rate paid by Federal Reserve Banks on short-term loans to depositary institutions.

Reserve requirements are the portions of deposits banks have to keep either in their vaults or on deposit with a Federal Reserve Bank. Additionally, the Federal Reserve has the power to modify the reserve requirements of the banks, which defines the amount of reserves that a bank must maintain relative to the defined deposit obligations. The bank has to keep a percentage of the defined deposits in vault cash or deposits with Federal Reserve banks, depending on the appropriate reserve ratio.