Question

What are the three traditional tools that the Federal Reserve uses to control (influence) the interest rate? Explain how each can be used to increase the money supply.

Answer 1

The three traditional tools used by the federal reserve are

Reserve requirement: commercial banks are required to keep a certain percentage of their deposits as reserves with the federal reserve Bank. This requirement is called reserve requirement. When the federal reserve wants to increase the money supply, it reduces the reserve requirement which encourages banks to release some of the reserves as loans. This will increase the liquidity in the market and thereby increase the money supply.

Discount rate: this is the rate at which the commercial banks can borrow loans from the federal reserve in case the reserve requirement are not met. The discount rate is also reduced in case the federal reserve is willing to increase the money supply. Again this will increase the amount of reserves available for loans and this will increase the liquid in the market. Eventually this will increase the money supply

Open market operations: federal reserve conducts open market purchases of governmemy securities. This is likely to increase the deposits in the bank which ultimately increases the amount of reserves in the system and create money.