Fed Tools

The Fed and Its Tools

The Fed has three primary tools at its disposal when attempting to change the money supply. I do not think there is a simple way to fix a recession; otherwise people smarter than me would have already taken these actions. However, with the use of its three tools, the Fed has the capability to rebound an economy out of a recession.

The first tool the Fed has to use to change the money supply and the economy is changing the required reserve ratio. This seems to me that it would be a very effective tool in affecting the economy. By manipulating the required reserve ratio, the Fed increases or decreases the amount of money supply in the economy. When the Fed wants to increase the money supply, it decreases the required reserve ratio and vice versa when it wishes to decrease the money supply. The Fed is reluctant to use this tool to manipulate the supply of money, but because it expands or reduces credit in every bank in the country it is a very powerful one (Case, Fair & Oster, 2009). It would seem that manipulating the required reserve ratio to increase the supply of money would be a quick fix to stimulate the economy. However, the more money available means the less it is worth. This could lead to further inflation, which is already an issue and thus not have the effect desired, if the Fed were to go this route.

The second tool the Fed uses to manipulate the money supply is known as the discount rate. The discount rate is the interest rate that banks pay to the Fed when they borrow money from it. The basic premise of the discount rate is when the Fed wishes to decrease the money supply, they raise the discount rate. When the Fed wishes to increase the money supply, they decrease the discount rate, which then in theory, would encourage banks to borrow more money from the Fed. It is now policy that The Fed set the discount rate above the rate those banks pays to borrow money in the private market (Case, Fair & Oster, 2009). This...