Explain the Fed's three tools of monetary policy and how each is used to change the money supply. Does each tool affect the monetary base or the money multiplier?

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The Fed uses three traditional tools of monetary policy to influence the money supply: open market operations, the discount rate, and reserve requirements. Each tool interacts with the banking system in a distinct way and affects either the monetary base, the money multiplier, or both.

Open market operations: The Fed buys or sells U.S. Treasury securities in the open market. When the Fed buys securities, it credits banks’ reserve accounts, increasing the monetary base (the sum of currency in circulation and reserves held by banks at the Fed). With a higher base, banks have more reserves to lend, which can expand the money supply through the money multiplier, since each new loan creates deposits that become part of the money supply. Conversely, when the Fed sells securities, reserves fall, shrinking the base and usually contracting deposits through a smaller multiplier effect. In essence, open market operations primarily change the monetary base directly and influence the money supply indirectly through the multiplier depending on the banking system’s response.

Discount rate: This is the interest rate banks pay to borrow directly from the Federal Reserve’s discount window. Lowering the discount rate makes borrowing cheaper for banks, increasing bank reserves and the effective money that can be created through loans, thus potentially expanding the money supply. Raising the discount rate has the opposite effect, discouraging borrowing from the Fed, reducing reserve growth, and dampening loan creation and the money supply. The discount rate affects the money supply indirectly by influencing banks’ willingness to borrow reserves and, therefore, their capacity to lend, which in turn can influence the money multiplier, while the direct mechanism is through changes in bank reserves rather than the base itself.

Reserve requirements: This is the fraction of deposits that banks must hold as reserves (either as cash in the vault or as deposits at the Fed). Reducing reserve requirements frees up more of a bank’s deposits to be lent, increasing the money supply by boosting the potential size of the money multiplier, with some effect on the monetary base since total reserves might be reduced as a result of higher lending and deposit creation. Raising reserve requirements tightens banks’ capacity to create new deposits, constraining the money supply by constraining the multiplier and, to a lesser extent, reserves. The primary channel is through the constraint or expansion of loanable funds, which directly alters the multiplier, while the base shifts only insofar as trading deposits for required reserves.

How each tool relates to the base versus the multiplier: Open market operations predominantly alter the monetary base directly, with the subsequent change in the money supply depending on banks’ lending behavior and the resulting multiplier effect. The discount rate influences the money supply mainly through banks’ demand for reserves from the Fed; it changes lending activity and the effective multiplier, with a minimal direct change to the base. Reserve requirements directly constrain or free up banks’ ability to create deposits, thereby targeting the money multiplier most strongly, while also affecting the base through the need to hold more or fewer reserves. In summary, the three tools operate through different levers: base manipulation (open market operations) and multiplier modulation (discount rate and reserve requirements), with their ultimate impact on the money supply shaped by how banks respond to these policy signals.

My home Week 11 Tutorial Quiz (Assessing Your Understanding of Week 10 Topic's Lecture: Ch16)

Explain the Fed's three tools of monetary policy and how each is used to change the money supply. Does each tool affect the monetary base or the money multiplier?

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