Question

What three options does the Federal Reserve have to steer the course of the economy? Which option is the most popular? Describe how this option increases or decreases the money supply.

Answer 1

The three options that the Federal reserve have to steer the course of the economy are:

Open market operations

Setting the discount rate

Setting the reserve requirements

Of all these, Open market operations is most popular

In open market operations,the Fed buys and sells government securities in the market which affects the reserves and the money supply.If there is Inflation going on then the Fed would want to reduce the money supply.To do this,the Fed will sell the government securities in the market which will reduce the money available with the banks which in turn affects the Federal funds rate at which banks borrow from each other.As the money reserves decrease,the banks will make fewer loans which will reduce the money supply in the market and controls the inflation as people would be less willing to take loans at a higher rate and so the aggregate demand falls.The opposite happens in the case of recession when the Fed would want to increase the aggregate demand by purchasing the government securities.