Tools Used By Fed To Pursue Monetary Policy

The first tool we will discuss is open-market operations. Open-market operations consists of the buying and selling of government securities from security dealers and large banks, therefore rising up the money supply in the hands of the people(Gopinath, 2008). Here, the FED doesn’t decide on its own of which securities it will engage in the business with. The option comes from the open-market in which several securities dealers, that the FED does business with, compete on the basis of price. Open-market operations are flexible and the most often used tool out of the three tools of monetary policy. The FED also uses open-market operations to control the supply of bank reserves. If the FED requires increasing reserves, it purchases securities and pays for them through making a deposit to a FED maintained account by the main dealer’s bank. If the FED needs to bring down reserves, it sells securities and collects on those accounts. In generalFED neither intends to increase, nor decline the reserves lastingly. It just engages regularly in transactions reversed within a period of one week.

The next tool that FED uses is the interest rate. The discount rate is simply the interest rate that banks pay on short-term loans from a Federal Reserve Bank. The discount rate is what the central bank charges commercial banks on loans for extra reserves. The rate is handed down and put by the FED, not the market rate, so its significance is what the FED is signaling to the financial arena. If the discount rate is low, the FED wants to support spending; if the discount rate is high, the FED is dispiriting spending by the financial markets.

To provide banks with greater reserves, the FED will cutdown the interest rate to attract borrowing by banks, thus increasing the money supply in the economy of the country. By making loans easier to obtain to the banks, the loans are made easier to be obtain by the people. When the FED increases the discount rate to discourage banks from lending, it makes loans from commercial banks to the public harder to obtain. This enables the FED to influence the money supply in the U.S. economy.

Finally, the third tool of monetary policy, used by the FED is change in the reserve ratio. This tool is not frequently used, but can be a very influential tool. A reserve ratio is the percentage of reserves a bank is needs to hold against deposits. Through decreasing the ratio, it allows banks to lend more, hence increasing the money supply in the economy. By increasing the ratio, banks will be obliged to lend less, causing a negative effect on the money supply.

All three tools tie together, in monetary expansion; following an open-market operation involves adjustments to be made by banks and by the public

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