Question

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.

Answer 1

There is an inverse relation between the interet rate and the money supply.

The three basic tool that the fed uses to control the money supply and the interest rates in the economy are :

1. Open market operations: this is buying or selling of securities to the public When the fed buys securities, it adds money to the economy because money is paid in return of the securities. Thus the money supply increases and the interest rate in the economy falls. When the fed sells of securities, it gets money in return, the cash holding in the economy is reduced and the money supply falls and the interest rate rises. This is also known as quantitative easing.

2. Reserve requirement: it is some fraction of money that the commercial banks are required to keep with themselves in the form of cash. Its a mandate by the central bank. When the reserve requirement ratio falls, less money is kept with the banks in the form of cash and the remaining amount (excess reserves) is lent out, and the money supply increases.

When the reserve requirement is increased, more money is to kept in te form of cash, the bank's excess reserves falls and the money supply in the economy reduces. Fed hardly uses this tool for expansionary/contractionary monetary policy as it is very expensive to change the reserve requirement.

3. Discount rate: its the rate that the central bank charges the commercial banks to borrow at its discount window. When the discount rate increases, the cost of borrowing also increases and the money supply decreases. Usually, the rate is high, commercial banks uses this tool only if they can't borrow funds from anywhere outside. Also, there is a stigma attached to it. Since only troublesome banks would use this tool of borrowing, so it creates a pessimistic belief about that commerical bank who borrows. As the discount rate falls, cost of borrowing reduces, and the supply of money in the economy increases.