Describe the monetary policy tools available to the Fed and

Describe the monetary policy tools available to the Fed and how they can be used to decrease the money supply.

Solution

The Fed has three main tools at its disposal to influence monetary policy:

Open-Market Operations - The term open market means that the Fed doesn\'t independently decide which securities dealers it will do business with on a particular day. The Fed constantly buys and sells U.S. government securities in the financial markets, which in turn influences the level of reserves in the banking system. These decisions also affect the volume and the price of credit (interest rates).

If Fed wants ot decrease money supply, it will sell securities because it will take cash from general public and give them paper securities.
2. Setting the Discount Rate - This is the interest rate that banks pay on short-term loans from a Federal Reserve Bank. The discount rate is usually lower than the federal funds rate, although they are closely related. The discount rate is important because it is a visible announcement of change in the Fed\'s monetary policy and it gives the rest of the market insight into the Fed\'s plans.

If Fed wants ot decrease money supply, it will decrease discount rates.

3. Reserve Requirements - This is the amount of physical funds that depository institutions are required to hold in reserve against deposits in bank accounts. It determines how much money banks can create through loans and investments. Set by the Board of Governors, the reserve requirement is usually around 10%. This means that although a bank might hold $10 billion in deposits for all of its customers, the bank lends most of this money out and, therefore, doesn\'t have that $10 billion on hand. Furthermore, it would be too costly to hold $10 billion in coin and bills within the bank. Excess reserves are, therefore, held either as vault cash or in accounts with the district Federal Reserve Bank Therefore, the reserve requirements ensure that depository institutions maintain a minimum amount of physical funds in their reserves.
If fed wants ot decrease money supply, it will increase reserve requirements.