Question

There are three specific ways available to the Federal Reserve to alter the money supply? Identify each method and explain each one works. Which one is applied most often and why is this the case?

Answer 1

The Fed uses three main tools alter the money supply in the economy-

1. A change in reserve requirements
2. A change in the discount rate
3. Open market operations

Reserve Ratio

A change in reserve ratio is seldom used, but is potentially very powerful. The reserve ratio is the percentage of reserves a bank is required to hold against deposits. A decrease in the ratio will allow the bank to lend more, thereby increasing the supply of money. An increase in the ratio will have the opposite effect.

Discount Rate

The discount rate is the interest rate the central bank charges commercial banks that need to borrow additional reserves. It is an administered interest rate set by the Fed, not a market rate; therefore, much of its importance stems from the signal the Fed is sending to the financial markets. As a result, short-term market interest rates tend to follow its movement. If the Fed wants to give banks more reserves, it can reduce the interest rate it charges, thereby tempting banks to borrow more. Alternatively, it can soak up reserves by raising its rate and persuading the banks to reduce borrowing.

Open Market Operations

Open market operations consist of the buying and selling of government securities by the Fed. If the Fed buys back issued securities such as Treasury bills from large banks and securities dealers, it increases the money supply in the hands of the public. Conversely, the money supply decreases when the Fed sells a security. The terms "purchase" and "sell" refer to actions of the Fed, not the public.

For example, an open market purchase means the Fed is buying, but the public is selling. Actually, the Fed carries out open market operations only with the nation's largest securities dealers and banks, not with the general public. In the case of an open market purchase of securities by the Fed, it is more realistic for the seller of the securities to receive a check drawn on the Fed itself. When the seller deposits it in his or her bank, the bank is automatically granted an increased reserve balance with the Fed. Thus, the new reserves can be used to support additional loans. Through this process, the money supply increases.

The monetary expansion following an open market operation involves adjustments by banks and the public. The bank in which the original check from the Fed is deposited now has a reserve ratio that may be too high. In other words, its reserves and deposits have gone up by the same amount; therefore, its ratio of reserves to deposits has risen. To reduce this ratio of reserves to deposits, it chooses to expand loans.

When the bank makes an additional loan, the person receiving the loan gets a bank deposit, increasing the money supply more than the amount of the open market operation. This multiple expansion of the money supply is called the multiplier effect. Open market operations are a widely used instrument as they are flexible, easy to use, and effective.