Question

The federal reserve has three major tools that it can use to control money supply growth and interest rates- reserve requirements, discount rate, open market operations. However, the fed relies exclusively on open market operations.

(A) Why doesn’t the fed use its reserve requirement and discount rate power?

(B) Why does the Fed reply so exclusively on open market operations?

Answer 1

A. The Fed doesn't use reserve requirements because a small change in reserve requirements can affect excess reserves with the banks. Note that banks lend the excess reserves to the public as loans. If reserve requirements are changed too often then it will result in a major shock to the economy. Similarly, the bank can borrow from Fed using the discount window. If the discount rates are changed too often then once again it would cause too much uncertainty among the banks. For e.g. if the Fed increases the discount rate then the banks might cut down on lending and hence increase their excess reserve. This will have negative impact on the economy.

B. The benefit of open market operations is that it has a direct impact on the money stock in the economy. This happens because of the Fed can conduct the sale and purchase of the securities. Thus it need not depend on actions on banks to affect the money stock in the economy. Also, it can be done on a regular basis unlike the interest rates which cannot be changed everyday.