Question

Question: The Federal Reserve Bank is responsible for monetary policy i.e., controlling the money supply. What tools do the Federal Reserve use to accomplish this? Discuss how banks create money and the role of the money multiplier. What is Quantitative Easing? How did the Federal Reserve use this tool during the recession?

Answer 1

The discount rate is the interest rate on short-term loans that Reserve Banks offer to commercial banks. Federal Reserve discount-rate lending complements open market operations in reaching the federal funds target rate and acts as a source of liquidity for commercial banks to back up. Lowering the discount rate is broad, since certain interest rates are affected by the discount rate. The lower rates allow customers and companies to lend and invest

Reserve requirements are the portions of reserves that banks are expected to keep in cash, either in their vaults or on a reserve bank account. A reduction in reserve requirements is expansionary as it raises the funds available for lending to customers and companies within the banking system. The rise in reserve levels is contractionary, as it limits the funds available for lending to customers and companies in the banking system. The Board of Governors has sole authority over changes to reserve requirements. The Fed's criteria for reserves rarely change.

Open market operations, the acquisition and selling of U.S. government securities, is a effective tool. As we heard earlier, this device is regulated by the FOMC and run by New York's Federal Reserve Bank.

The money multiplier would depend on the proportion of reserves the Federal Reserve Bank needs the banks to carry. In addition, a bank may also opt to keep additional reserves. Banks can choose to vary how much reserves they keep for two reasons: macroeconomic conditions and government regulations. When an economy is in recession, banks are likely to keep a higher proportion of reserves because they believe that when the economy is weak, loans will be less likely to be repaid. Also, the Federal Reserve can increase or lower the necessary reserves held by banks as a policy step to influence the amount of money in an economy, as we will address the monetary policy module in greater detail.

The most effective and widely used of the three conventional monetary policy instruments — open-market operations— works by expanding or contracting the money supply in a way that affects the interest rate. As the U.S. economy struggled with recession in late 2008, the Federal Reserve had already reduced the interest rate to close to zero. The Fed agreed to pursue an ambitious and non-traditional approach known as quantitative easing (QE), as the recession continues. It is the acquisition by central banks of long-term government and private mortgage-backed securities to provide credit so as to increase aggregate demand.