The Tools the Fed Uses to Control the Money Supply
The United States monetary policy is managed by the Federal Reserve System (Fed), which has four main tools. The first instrument is the open market operation, which allows the Fed to enhance the reserve in the economy by buying and selling government security on the open market, helping to affect the federal fund rate. Second, by adjusting the reserve requirement ratio, the Fed can alter the reserve requirement effect in the market and, thus, the federal fund rate. This instrument requires banks to keep a fixed percentage of their deposits on hand as reserves (Abolafia, 2020). Third, the discount rate is the interest percentage at which financial institutions such as banks borrow money from the Fed for relatively short periods. Lending by banks, and thus the money supply in the economy, is sensitive to changes in the discount rate. Interest on the excess reserve is the fourth category, which refers to the extra funds that banks keep with the Fed. The money supply in banks is influenced by interest on excess reserves.
How These Tools Can Be Used to Control the Money Supply
The Fed can increase or decrease the money supply by augmenting or lowering the number of reserves in the banking system through open market purchases of bonds, bills, and other monetary instruments. The sale of these products by the central bank removes funds from circulation. When the Fed sells government assets on the open market, it lowers the money supply by the amount received in exchange for the securities (Clarida, 2020). The Federal Reserve’s purchase of government securities expands the money supply because of the Fed’s payment to the public, an increase in bank deposits and reserves, the creation of surplus reserves, and a decrease in the federal finance rate.
The reserve ratio is a powerful instrument for the Federal Reserve in its monetary policy toolkit. To boost the economy’s money supply, the Fed could decide to reduce the reserve ratio. Borrowing becomes more appealing to consumers when banks are allowed to lend more money to clients at lower interest rates due to a reduction in the required reserve ratio. The Fed determines the reserve requirement ratio, and banks have a lesser need to keep in reserve when that ratio falls. When the ratio decreases, the bank has sufficient funds to lend out, thereby increasing the money supply (Bernanke, 2020). The money supply decreases because of a rise in the ratio since fewer bank funds are available.
When the discount rate rises, the Federal Reserve becomes a less attractive funding source for banks. Reducing bank borrowing will decrease overall banking system reserves and slow the flow of money into the economy (Abolafia, 2020). Consequently, when the discount rate is raised, banks are less likely to borrow money from the central bank, reducing the amount of money available for lending. In contrast, an increase in the money supply results from a lower discount rate since the Fed can lend more and bank reserves grow.
Since most institutions would not be prepared to loan out their reserves at terms below what they can profit from, the interest rates offered on excess reserves operate as a ground beneath the Fed funds rate. Controlling the federal funds rate relies heavily on reserve interest rates (Clarida, 2020). When banks earn more interest on their excess reserves, businesses will likely increase their funds, leaving less cash available for lending and reduced money supply. If interest rates were lowered, more money would be available for lending, and less would be held in reserve, resulting in a rise in the money supply.
Identification and Explanation
The Fed mostly employs open market operations and seldom uses the reserve requirement ratio and discount rate. The less profit a bank generates with its money, the higher the reserve ratio. It is costly for financial institutions to adjust the reserve requirement. Accordingly, they have no choice but to adjust their systems (Shapiro & Wilson, 2022). Thus, the Fed board rarely adjusts the reserve requirement. The Fed rarely uses the discount rate to effect monetary policy since it is difficult to predict the amount borrowed. This is because it is unclear how a reduction or increase in the discount rate will affect the financial markets.
Recent Actions
The central bank has reduced interest rates to historically low levels and pledged to keep increasing its bond holdings to maintain credit availability. To aid the economy’s recovery from the coronavirus pandemic, the Federal Reserve announced in the middle of 2020 that it would keep its base interest rate near zero through 2022 (Clarida, 2020). The Fed anticipates a gradual implementation of its financial view (Caballero & Simsek, 2022). Historically low borrowing costs have made loans more affordable when millions of Americans are out of work, and many feel extremely cash-strapped.
Evaluation of Actions
When the Fed funds rate fluctuates, it affects other interest rates, swaying the cost of borrowing money for consumers and businesses. When interest rates drop, for instance, consumers are likely to spend money on products and services (Shapiro & Wilson, 2022). Additionally, companies can invest easily in growth by purchasing new facilities and machinery with their accumulated savings. The Fed’s actions would influence my decision to remain in the workforce and shelve the idea of returning to school. This is because it influences employment by providing conditions for enterprises to expand their workforces. It is also possible that salary increases due to the growing demand for products and services.
References
Abolafia, M. Y. (2020). Stewards of the market: How the Federal Reserve made sense of the financial crisis. Harvard University Press.
Bernanke, B. S. (2020). The new tools of monetary policy. American Economic Review, 110(4), 943-983. Web.
Caballero, R. J., & Simsek, A. (2022). Monetary policy with opinionated markets. American Economic Review, 112(7), 2353-2392. Web.
Clarida, R. H. (2020). The federal reserve’s review of its monetary policy strategy, tools, and communication practices. Cato Journal, 40, 255-267. Web.
Shapiro, A. H., & Wilson, D. J. (2022). Taking the fed at its word: A new approach to estimating central bank objectives using text analysis. The Review of Economic Studies, 89(5), 2768-2805. Web.