The tools used by the Federal Reserve to control the money supply
There are three tools that the Federal Reserve (The Fed) uses to control the money supply. The first tool is the Spread between the Discount Rate (DR) and the Federal Funds Rate (FFR). This spread determines if banks will be more inclined to borrow from the Fed or from other banks. The Second tool the Fed uses to control the money supply is the Required Reserve Ratio (RRR). The Fed mandates a percentage (ratio) of deposits that bank are required to hold in reserves and not lend out. The Third tool the Fed uses to control the money supply is Open Market Operations (OMO). OMO includes Treasury Bills (T-bills), bonds, securities, and other instruments sold to investors by the Fed.
The Spread between the DR and the FFR
The money supply is affected by the by spread between the DR and the FFR If the Fed DR is lower than the FFR charged by other banks, it is more probable that banks will borrow from the Fed. As the DR decreases, increasing the spread between the DR and the FFR, banks borrow from the Fed which will increase the money supply. However, if the Fed DR is higher than the FFR charged by other banks, then banks will always borrow from other banks. When banks borrow from other banks it does not affect the money supply.
Required Reserve Ratio (RRR)
The RRR affects the money supply because if the required ratio increases banks are required to hold more money in reserve. This will decrease the money supply because banks are not able to lend out as much money to customers. Conversely, if the required ratio decreases banks are required to hold a lesser amount of money in reserve therefore increasing the money supply because banks can lend out more money to customers.
Open Market Operations
OMO investment instruments are usually bought and sold by investors through auctions, which affect the money supply. When financial instruments, like T-bills or securities are sold this decreases the money supply because the Fed accepts money in return for a promise to pay. The same is true in reverse. When financial instruments are bought back by the Fed this increases the money supply because the Fed pays out hard currency in exchange for accepting securities.
Monetary policy is the process by which governments and central banks manipulate the quantity of money in the economy to achieve certain macroeconomic and political objectives. The targets are usually: - economic growth, changes in the rate of inflation, higher level of employment, and adjustment of the exchange rate. Monetary policy is categorized into two types: Contractionary and expansionary. Contractionary (or “tight”) monetary policy aims to reduce the amount of money circulating through the economy, and reduce short-term economic growth in exchange for higher (hoped-for) long-term growth. Expansionary (“loose”) policy, on the other hand aims to increase the money supply and increase...