Question

Define and detail the tools used by the FED to manage the nation’s money supply.

Answer 1

The Federal Reserve uses several tools to manage the money supply. The primary tools used by the Federal Reserve are as follows -

1. Open Market Operation
2. Discount Rate
3. Required Reserves
4. Interest on Excess Reserves

Open Market Operation - The fed engages in buying and selling of bonds in the open market and this is the primary tool used by the fed to alter money supply. When the fed wants to increase money supply, the fed buys bonds from the open market with banks and financial institutions being the sellers. This infuses liquidity in the banking system and drives down the federal fund rate. The interest rate also declines in the economy. On the other hand, when the fed wants to reduce money supply, the fed sells bonds in the open market, which is bought by banks and financial institutions. This absorbs liquidity from the financial system and money supply is tightened.

Discount Rate - This is the rate at which the federal reserve lends to commercial banks. When the fed wants to increase money supply and lower interest rates, the fed lowers the discount rate. At lower cost of funds, banks are increasingly willing to borrow from the fed and money supply in the banking and economic system increases. On the other hand, when the fed wants to tighten money supply, it increases the discount rate and banks are less willing to borrow from the fed at higher cost of funds. This tightens money supply and interest rate trends higher.

Required Reserve - Banks have to maintain a minimum reserve as a percentage of deposits under the fractional reserve banking system. When the fed wants to increase money supply, the fed lowers the required reserves and banks have excess reserves that can be loaned. This increases money supply and lowers interest rates. When the fed wants to reduce money supply, the fed increases the reserve requirement and banks have less amount to loan out. As money supply declines, interest rates trend higher. This tool is rarely used by the fed.

Interest on Excess Reserves - This is a fairly new tool used y the federal reserve. When the fed wants to increase money supply, it lowers the interest rate it offers to banks for parking money with the fed. The banks have less incentive to keep excess reserves with the fed and money supply increases. On the other hand, when the fed wants to reduce money supply, it increases the interest rate it offers to banks for parking money with the fed. The banks have more incentive to keep excess reserves with the fed and money supply declines.