Question

Discuss and explain the FED's three tolls for changing the money supply and interest rate to stable the economy. (Monetary Policy, using a graph)

Answer 1

FED uses various tools to control money supply and interest rates to bring the economy back to equilibrium. Three of those tools are:

1. Reserve ratio: It is the percentage of reserves banks are supposed to hold as a percentage of deposits. When the Fed decreases the reserve ratio, banks can lend more money and this increases the money supply. The opposite takes place when the Fed increases the reserve ratio.

2. Discount rate: This is the rate charged by the Fed from commercial banks when the latter borrow additional reserves. It is also seen as a signal Fed is sending to financial markets. So the markets follow these rates. Fed can reduce the discount rate, thus encouraging banks to borrow more and increase money supply. On the contrary, It increases the discount rate if it intends to reduce the money supply.

3. Open market operations: This involves bying or selling of government securities by the Fed. If it wants to increase the money supply, it purchases the government securities, and gives moeny in return which increases the money supply in the public. Opposite happens when it sells the government securities and gets money from the banks or dealers.

Graph:

  

From the above graph, we see that when the money supply increases the interest rate falls, and when money supply decreases, the interest rate rises. The Fed will increase or decrease the money supply through its tools.