One of the policies the United States government has to control the supply of money is the monetary policy. This policy recommended to the president of the United States by the Federal Reserve Board by using tools to control the supply of money. Tools used to control the supply of money by the Federal Reserve Board are open-market operations, the reserve ratio, and the discount rate. This paper explains how the Federal Reserve Board uses these tools to control the supply of money, explains how the tools influence the money supply and macroeconomic factors, how money is created, and recommended monetary policy.
The Federal Reserve Board
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Open-market operations consist of the buying of government bonds from, or the selling of government bonds to, commercial banks and the public (McConnell & Brue, 2004). Open-market operations are considered to be the most important tool for the Federal Reserve Board to influence the supply of money. When the Federal Reserve banks buys government bonds from commercial banks or the public, the reserves of the commercial banks will increase. The commercial banks releases part of the holdings (government bonds) to the Federal Reserve Banks and in purchasing the securities, it will increase the reserves of the commercial banks by the amount of bonds purchased. When the Federal Reserve banks buys securities form the public, the process is similar. When these securities are sold, the affect is the opposite; the reserves of the commercial banks will decrease. A decline in commercial bank reserves produces a decline in the nation’s money supply (McConnell & Brue, 2004).
The Federal Reserve Board can also control or change the reserve ratio to influence the ability of commercial banks to lend. The Federal Reserve Board does this by raising or lowering the reserve ratio. Raising the reserve ratio will increase the amount of money the banks must keep in reserve. By increasing the reserve ratio, the banks either lose excess reserves, diminishing their ability to create money by lending, or they find their reserves deficient and are forced to contact checkable deposits and therefore the money supply (McConnell & Brue, 2004). Lowering the reserve ratio changes reserves required by the Federal Reserve Board in to excess reserves and increases the ability of banks to create new money by lending.
One of the functions of a central bank is to be a “lender of last resort” (McConnell & Brue, 2004). When banks need short-term loans on an emergency basis or unexpected basis, the Federal Reserve Bank will make short-term loans to the commercial banks in their district. As the commercial bank borrows money, interest is charged on the loan called the discount rate. Borrowing money from the Federal Reserve banks by commercial banks will increase the reserve of those banks and increase the ability to extend credit. By increasing the discounted rate, the commercial banks will hesitate on borrowing money to increase the credit line because it will cost them more money. The Federal Reserve bank will increase the discounted rate to restrict the money supply (McConnell & Brue, 2004). Of the three tools of controlling the monetary control, buying and selling securities on the open market is the most important (Kapoor, Hughes, Pride, 2010).
Increasing and Decreasing the Money Supply
To increase the money supply, the Federal Reserve Board can lower reserve requirements, reduce the discount rate, and buy more bonds. By lowering the reserve requirements, it will increase the banking system’s excess reserves with which they will increase the money supply through deposit...