ECON 100 Federal Reserve Tools Discussion

St. Charles Community College 
ECON 100    Survey Economics 
Class Discussion Question

 

The Federal Reserve Board has three tools or methods that it can utilize to control the money supply.  Explain how each of these tools works to accomplish this objective. 

Answer:

The three tools for controlling the money supply that are available to the Federal Reserve Board are:

· It can increase or decrease the reserve ratio. 
· It can increase or decrease the discount rate. 
· Its Open Market Committee can buy and sell government debt issues.

It is important to remember here that the common thread is that the Federal Reserve Board works through the banking system to control the money supply.

Now let’s take each of these Fed tools separately.

The Reserve Ratio

The ratio of bank reserves that must be retained by the banks is set by the Fed.  This means that a certain percentage of all funds taken in by banks must be retained by those banks.  If the Fed decreases the reserve ratio, banks have more money to lend out and place in circulation.  When loans are made to consumers and to firms, the money multiplier takes over, and the money supply increases as additional money enters the economy.

In like manner, if the Fed increases the reserve ratio, banks must retain larger percentage of their reserves which means that they will have less money to lend out to consumers and firms.  When the reserve ratio increases, the money multiplier decreases, and the amount of money in circulation decreases. 

The Discount Rate

The discount rate is the interest rate that the Fed charges member banks when those banks borrow from the Fed.  Generally this is done on a short term basis when those banks need to temporarily increase their reserves.

When banks borrow from the Fed, their costs go up.  They must then pass these increased costs on to their customers in the form of higher interest rates.  These increased interest rates tend to discourage borrowers so that less money is loaned out.  With less money being loaned out by the banks, there is a smaller amount of money going onto the economy through the money multiplier.

Banks are generally hesitant to use this tool because of the costs involved, so this tool is not commonly used.

The Open Market Operations

The Open Market Committee, operating out of the New York Federal Reserve Bank, buys and sells government debt issues (government bonds, Treasury notes, and Treasury bills) in the open market to change the money supply.  The debt issues are normally short term instruments that are owned by banks, insurance companies, foreign governments, large corporations, and private investors.

The Federal Reserve Board owns a large amount of these government debt instruments and buys and sells them for their own account each business day.  When the Fed purchases the instruments, they take in the bonds and pay for them in cash which places additional money in the economy.  On the other hand, when the Fed sells the bonds, they take in the cash which removes money from the economy.

The specific manner in which the Fed accomplishes this activity is that the Fed has a list of thirty to thirty-five “primarily dealers” with whom they work.  When the Fed buys these short term instruments from these dealers, the dealers place the money from these sales in their accounts in their respective banks, and the money multiplier takes over again distributing that money throughout the economy. The opposite happens when the Fed sells bonds through these dealers in that the dealers pay for the bonds out of their individual bank accounts and money is taken out of the system.

This is the most common method that the Federal Reserve Board uses to control the money supply.