Question

A. Explain in detail the 3 primary tools of Monetary Policy the Federal Reserve uses to change the money supply and interest rates in the economy.


B. Which tool is the most important? Explain why.

Answer 1

Answer B. Reserve requirement tool is most important and effective; it controls the money supply in very easy way. (Reason is same as answer A's point A)

Answer A. There are basically two types of monetary policy. Namely Quantitative (Money supply) Credit Control Measure and another is Qualitative credit control measure.

But every country and its apex bank that is country’s central bank uses the mostly quantitative credit control measure.

These measures or we can call it tools of monetary policy are followed by federal reserves or central bank are as follows.

A.. Changes in reserve requirements / Variable reserve ratio.

B.. Bank rate / Discount rate

C.. Open market operations.

            We will try to understand these concepts in brief.

A.. Changes in reserve requirements / Variable reserve ratio.

Reserve ratio means the commercial bank have to maintain the certain amount of cash holdings with them according to deposit ratio and have to keep certain amount of cash reserves with central bank (federal reserve). Once the federal reserve changes the reserve requirement percentage the commercial bank will effect on their loans and advances. Suppose if Federal Reserve increases the ratio then less money holding remains with banks and money supply is less for lending purpose. A decrease in ratio will allow the bank lend more and money supply is increasing.

B.. Bank rate / Discount rate

This rate means the central bank charges the interest rates to the commercial bank who borrows additional reserve. This rate is purely determined by the federal reserve and not by market demand supply basis. This rate can absorb the excess money supply from the economy as well as can inject the money supply.

C.. Open market operations.

In open market operations Fed is buying and selling the government securities. There participants are like commercial banks, HNI, stock brokers, dealers and can individuals also. If Fed is buying the government securities then it seems to be they were injecting the money and money supply is increased, as well as went hey are selling the government securities it means there absorbing the excess money supply from the economy. In general, open market operations, the only government issued treasury bills were sell and buy.