Question

U.S. monetary policy is set by the Federal Open Market Committee (FOMC). The purpose of the policy is to encourage maximum employment, stable prices, and reasonable long-term interest rates.  

Questions:

Discuss the tools the Federal Reserve uses to control monetary policies. Include the objective each tool is used to deliver. Expand on how the Federal Reserve System uses the interest rate to affect the money supply.

Answer 1

The tools used by the Federal reserve to control monetary policies are :

• discount rate,
• reserve requirements,
• open market operations.

Discount rate is the rate charged by banks to borrow funds from the Fed. Fed prefers that banks borrow from each other instead of borrowing from the Fed. So, the rate fixed by Fed is generally high. So, banks do not borrow from Fed until and unless the banks bank are not lending.

Reserve requirement: This is the amount of deposits kept by the banks as reserves. As the central bank reduces the reserve requirement that is the amount of reserves kept by banks is reduced, the lending capability of the banks is increases. So, this enhances the liquidity in the markets and interest rates are brought down. By increasing the reserve requirement, they bring down liquidity in the markets.

Open market operations: Fed buys from the banks and pumps money into the system, similarly when the Fed sells securities to the banks , it reduces liquidity in the system. This changes the reserve amount that banks have on hand without changing the reserve requirement.

The FED uses the interest rate to control money supply : By lowering the interest rates, they market borrowing money easy , so people borrower more, spend more the purchasing power is increased and the economy experiences a boom.

Similarly, when the increase the interest rates, the money supply in the economy is reduced. By increasing the interest rates, the money supply is brought down , this strategy is used to bring down the inflationary pressures in the economy.