What are the four principal tools of monetary policy? Explain how they can be used.

Question

What will be an ideal response?

Answer 1

The Federal Reserve Banks use four principal tools (techniques or instruments) to control the reserves of banks and the size of the money supply. (1) The Federal Reserve can buy or sell government securities in the open market to change the lending ability of the banking system: (a) buying government securities in the open market from either banks or the public increases the excess reserves of banks; (b) selling government securities in the open market to either banks or the public decreases the excess reserves of banks. (2) The Fed can raise or lower the reserve ratio: (a) raising the reserve ratio decreases the excess reserves of banks and the size of the monetary (check able-deposit) multiplier; (b) lowering the reserve ratio increases the excess reserves of banks and the size of the monetary multiplier. (3) The Fed can also raise or lower the discount rate: (a) raising the discount rate discourages banks from borrowing reserves from the Fed; (b) lowering the discount rate encourages banks to borrow from the Fed. (4) The Federal Reserve pays interest on reserves that commercial banks hold at the Federal Reserve. The Fed’s ability to pay interest on reserves can be used as a monetary policy tool: (a) increasing the interest rate on reserves held at the Fed increases the incentive banks will have to reduce risky lending; (b) if the Fed prefers to increase the bank loans, they may reduce the interest rate to encourage lending.