- The three monetary tools used by the fed are the following:
Open market operations - Open market operation is an activity by the fed to give liquidity in its currency to a the banks by either buying or selling government securities.
The discount rate - The discount rate is how much the U.S central bank charges the member banks to borrow in order to maintain their reserves.
Reserve requirements - These are funds that a bank holds in reserve so as to meet its liabilities in case of increased withdrawals.
Open market operations:
Selling securities - decreased money supply - increases in interest rates - decrease in aggregate demand
Buying securities - Increase in money supply - decrease in interest rates - increase in aggregate demand
High discount rate - decrease in money supply - increase in interest rates - decrease in aggregate demand
Low discount rate - increase in money supply - decrease in interest rates - increase in aggregate demand
High reserve requirements - decrease in money supply - increase in interest rates - decrease in aggregate demand
Low reserve requirements - increase in money supply - decrease in interest rates - increase in aggregate demand
Open market operations
If the fed wants to lower the money supply in the economy, it will sell government securities to the banks which reduces reserves and amount available for banks to lend. This raises interest rates for loans which decreases capital investment and eventually decreases aggregate demand
If the fed wants to raise money supply in the economy, it purchases securities from the banks which increases bank reserves. With more reserves, banks can lower the interest rates and more borrowing means the money supply in the economy will increase, which increases capital investment and an increase in aggregate demand as it becomes less costly to borrow.
The discount rate
If the fed raises discount rate, the banks will pay higher interest rates for overnight borrowing and this will force the banks to raise interest rates for loans as well. This will reduce available reserves in commercial banks and the high interest rates will discourage people from borrowing which decreases money supply. With high interest rates, less capital is invested and aggregate demand will go down.
If the fed decreases the discount rate, commercial banks can easily get overnight loans for their lenders and can easily lower their interest rates. This will make it easier to borrow resulting to increased money supply which encourages more investment and when capital investment increases and as people gain more income from jobs, aggregate demand increases as well.
If the government raises the reserve requirement for banks, they will have more for reserves and less to lend to borrowers decreasing money supply. This will cause an upward pressure on interest rates to offset the excess demand and as a result less money will be invested, less capital means less income for people and this translates to decreased aggregate demand
If the government decreases reserve requirements, the banks can lend more which makes them charge lower interest rates and as a result the borrowers can invest more because of increased money supply and capital investment will create more jobs and eventually raises aggregate demand in the economy.