Money Supply
The Federal Reserve can control the money supply through open market operations, changing the required reserve rate, the percentage of deposits that banks must maintain on reserve as cash deposits at the Federal Reserve banks, and by changing the discount rate, the rate of interest at which the Fed lends money to banks (Federal Reserve System). This paper describes how these tools can be used during times of too rapid growth and economic recession and recommends policy for our current economic situation.
To slow down an economy that is growing too quickly, the Federal Open Market Committee can sell securities of the Department of the Treasury on the open market to reduce bank reserves and raise the federal funds rate. Further, raising the required reserve ratio will mean that banks can't create as much money. And, by raising the discount rate, the Fed discourages banks from borrowing money from the Fed.
During an economic recession, the Fed can purchase U.S. Treasury securities on the open market from the public and banks. This will inject cash into the economy, expand bank reserves and lower the federal funds rate. Thus, banks have more money to lend to businesses and consumers. Lowering the required reserve ratio will allow banks to create more money. Lowering the discount rate encourages banks to borrow from the Fed, increasing the money supply and expanding the economy.
Presently, the Fed should use its tools to slightly slow down the economy. This will have the benefit of slowing the pace of investment in areas where it has been too rapid and fending off inflation. Higher interest rates will also increase private savings. However, higher interest rates are will slow consumer spending which has been the strongest factor in the economic recovery (Shapiro, 2004). Rising rates may also have a negative impact on housing and business investment. Additionally, with the U.S. trade and current account deficits at record levels, higher interest rates will strengthen the dollar and further expand these deficits, further slowing growth.
Bibliography
Federal Reserve System. MSN Encarta. Retrieved July 31, 2004 from Web site: http://encarta.msn.com/text_761574452____4/Federal_Reserve_System.html
Shapiro, R. (2004, June 30). The economic outlook for the United States. Center for American Progress. Retrieved July 31, 2004 from Web site: http://www.americanprogress.org/site/pp.asp?c=biJRJ8OVF&b=105615
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