Question

Discuss the three (3) traditional monetary policy tools that the Federal Open Market Committee (FOMC) uses to affect interest rates and money supply in the economy.

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Answer 1

Federal Open Market Committee (FOMC) frames the monetary policy in the United States with the objective of achieving full employment and controlling inflation. With the help of monetary policy, FOMC controls the supply of money. Monetary policy helps to promote the growth & stability of the economy. The three traditional monetary policy tools that Federal Open Market Committee (FOMC) uses to affect interest rates and money supply in the economy are:

1) Open market operations: It involves the buying and selling of U.S. government securities in the open market. In order to increase money supply, open market purchase is made which increases the bank reserves which they can use to lend money & thereby causing money supply to expand. Whereas, in order to reduce the money supply, open market sale is made which takes the money out of circulation & therefore, reduces money supply.

2) Discount rate: It is the interest rate that Federal Reserve charges when banks borrow money from it. Discount rate influences other interest rates. Banks borrow from Federal Reserve in order to increase their reserves which allows them to make more loans & create more money. When discount rate is lowered then it encourages lending & spending by individuals & businesses whereas when discount rate is raised, it discourages lending & spending activities by individuals & businesses.

3) Reserve requirements: Reserve requirements includes cash reserve ratio & statutory liquidity ratio that requires bank to either to hold portion of deposits in cash or as deposits with Federal Reserve. When reserve requirements are lowered then it leads to more funds available in the banking system, so, it enables banks to lend more money to individuals & businesses while when the reserve requirements are increased then it reduces the funds available in the banking system to lend to individuals & businesses.