Question

List the policy tools available to the FED and sketch the way in which each tool works to change the supply of money.

Answer 1

Solution:-

Three main tools available to the Fed to change the money supply in the economy

1. Change the discount rate (a rate at which banks borrow from Fed)

2. Change the Federal Funds Rate via "Open Market Transactions" (buying and selling gov't bonds on the open market).

3. Changing the required reserve ratio (the percentage of demand deposits that a bank must hold as reserves).

2 is by far the most commonly used tool. Whenever you read about the Fed "changing the interest rate" they are referring to open market transactions & the Federal Funds Rate. Since they cannot set the rate directly, but do it indirectly by buying and selling bonds on the open market, they usually refer to the desired interest rate as the "target" rate.