4. List and briefly describe the three primary tools the Fed has to control the

Question

4.  List and briefly describe the three primary tools the Fed has to control the money supply and how all three can specifically be used to either increase or decrease the money supply.  In other words, how must the tools you list be used to raise the money supply?  To lower the money supply?

List and briefly describe the three primary tools the Fed has to control the money supply and how all three can specifically be used to either increase or decrease the money supply. In other words, how must the tools you list be used to raise the money supply? To lower the money supply?

Explanation / Answer

The Federal Reserve System has three tools that, in principle, can be used to control the money supply and interest rates. ======================================================================== Open Market Operations: The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of excess reserves that banks have available to make loans and to create money. This is the primary monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more reserves which they use to make more loans at lower interest rates and increase the money supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make fewer loans at higher interest rates and decrease the money supply. ======================================================================== Discount Rate: The Fed can also adjust the interest rate that it charges banks for borrowing reserves. Higher or lower rates affect the amount of excess reserves that banks have available to make loans and create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which they can use to make more loans at lower interest rate, which then increases the money supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use to make fewer loans at higher interest rates, which then decreases the money supply. Changes in the discount rate are most often used as a signal for monetary policy actions. ======================================================================== Reserve Requirements: The Fed can further adjust the proportion of reserves that banks must keep to back outstanding deposits (the reserve ratio). Higher and lower rates affect the deposit multiplier and the amount of deposits banks can create with a given amount of reserves. If the Fed lowers reserve requirements, then banks can use existing reserves to make more loans and thus increase the money supply. If the Fed raises reserve requirements, then banks can use existing reserves to fewer more loans and thus decrease the money supply. This tool is seldom used as a means of controlling the money supply

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