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

a) Three primary tools of the fed reserve to manage the money supply in the economy are:

• Reserve rates: It is the rate which the banks have to keep with the FED and it is generally a proportion of the total saving and current account deposit they have with them. Higher the rates the lower liquidity in the market.
• Discount rate: Discount rate are the rates at which the Fed lends to the banks. If the discount rates are high the banks will be borrowing less from the Fed and liquidity will be less in the market.
• Open market operations: It involves selling and buying of government bonds in the open market. If the fed is buying bonds it will release excess liquidity in the market and if they are selling bonds they are absorbing liquidity from the market.

b) Discount rates are the most important tools is the economy. It can be adjusted just by a notification and have a wide effect on the economy because it regulates lending facilities and borrowing capacity of the individual and firms.