Question

What are the three tools of the Federal Reserve for controlling money supply?

What is the difference between the Discount Rate and the Federal Funds rate?

If banks need to borrow money to meet reserve requirements, how do they get that money and from whom?

What is the equation that represents the “Quantity Theory of Money”? What do each of the terms mean?

Answer 1

a) Tools of the Federal Reserve for controlling money supply are:

1. Bank rate: The bank rate is the rate at which the central bank gives credit to the commercial banks. The increase or decrease in the bank rate is often followed by increase or decrease in the market rate of interest. Accordingly, the cost of credit changes the market. During inflation, the cost of capital is increased by increasing the bank rate. This reduces the flow of credit, as desired. On the other hand, during deflation, the cost of capital is reduced by reducing the bank rate. This increases the flow of credit.

2. Open market operation: Open market operation is the sale and purchase of government securities in the open market by the central bank. By selling the securities, the central bank withdraws cash balances from the economy. And, by buying the securities, the central bank adds to cash balances in the economy. During inflation, central bank sells government securities and reduce the money supply and on the other hand, during deflation, central bank buy government securities.

3. Cash reserve ratio: It refers to the minimum percentage of a bank's total deposits required to be kept with the central bank. Commercial banks have to keep with the central bank a certain percentage of their deposits in the form of cash reserves as a matter of law. When the flow of credit is to be increased, minimum reserve ratio is reduced and vice-versa.

b) Discount Rate: It is the minimum interest rate at which Federal reserve lend money to commercial banks.

Federal funds rate: It is the interest rate at which one bank lend money to other for overnight.