Federal Reserve Tools for Controlling the Money Supply

Introduction

The Federal Reserve can control the money supply through three primary tools: open market operations, the required reserve ratio, and the discount rate. The required reserve ratio is the percentage of deposits that banks must maintain on reserve as cash deposits at the Federal Reserve banks. The discount rate is the rate of interest at which the Fed lends money to banks (Federal Reserve System). This paper describes how these tools can be applied during times of too-rapid economic growth and during economic recession, and recommends policy for the current economic situation.

Slowing an Overheating Economy

To slow down an economy that is growing too quickly, the Federal Open Market Committee can sell U.S. Department of the Treasury securities on the open market to reduce bank reserves and raise the federal funds rate. Additionally, raising the required reserve ratio means that banks cannot create as much money. Finally, by raising the discount rate, the Fed discourages banks from borrowing money from the Fed, further contracting the money supply.

Stimulating Growth During Recession

During an economic recession, the Fed can purchase U.S. Treasury securities on the open market from the public and banks. This injects cash into the economy, expands bank reserves, and lowers the federal funds rate, giving banks more money to lend to businesses and consumers. Lowering the required reserve ratio allows banks to create more money. Lowering the discount rate encourages banks to borrow from the Fed, further increasing the money supply and expanding the economy.