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Federal Reserve works with three main policy tools -- reserve requirements, the discount rate and open market operations (St. Louis Fed, 2017). Each of the three has its strengths and limitations. They influence the amount of economic activity in different ways, which makes each one slightly different in how frequently it is used.
The discount rate is setting the rate at which banks can borrow money, which basically sets the baseline cost of money in the economy. The discount rate is used frequently because it is relatively easy to adjust, and has an immediate impact on the cost of money throughout the economy. In addition, the Federal Reserve will often telegraph its interest rate moves, as a means of influencing the economy even before the move occurs, so that the change ends up being more gradual than it otherwise would have been. The discount rate, because it affects the price of money, works by influencing the demand for money -- the more costly that money is, the fewer people will want to borrow.
Reserve requirements are the percentage of funds that banks need to hold back in reserve. By adjusting these, the Federal Reserve is directly influencing the amount of money that is released into the economy....
This is a seldom-used tool, with good reason. Essentially, if reserve requirements are loosened, this increases the supply of money in the economy, which should lower its price. But it does not necessarily increase demand. The bigger issue, however, comes if reserve requirements need to be tightened. Such an action could trigger banks to call in loans prematurely in order to boost their reserves. That would have a substantial cooling effect on the economy, and it would be shocking. Businesses could be put into bankruptcy if forced to pay back their loans ahead of schedule. So the real risk with using reserve requirements to influence the money supply comes if they ever need to be tightened.
The third tool are the open market operations. These are the most frequently used. They directly influence the quantity of money in the economy. The Federal Reserve buys or sells Treasury Bonds, so when it buys it puts money into the economy and when it sells it takes money out of the economy. The Federal Reserve can do this on a daily basis. It can buy and sell bonds with different terms, too, and has become more active in conducting open market operations with longer-term bonds in recent years. This tool is the…
References
St. Louis Fed (2017) How monetary policy works. Federal Reserve Bank of St. Louis. Retrieved April 26, 2017 from https://www.stlouisfed.org/in-plain-english/how-monetary-policy-works
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