Question

Explain how the Federal Reserve uses its tools to affect Investment and consumer spending. (please outline the 3 main tools and the different 'steps' involved)

Answer 1

The Fed can use four tools to achieve its monetary policy goals: the discount rate, reserve requirements, open market operations, and interest on reserves. All four affect the amount of funds in the banking system.

The discount rate is the interest rate charged on short-term loans by Reserve Banks to commercial banks. Lending at the discount rate by the Federal Reserve complements open market operations in reaching the federal funds target rate and serves as a source of liquidity backup for commercial banks. Reducing the discount rate is expansive because other interest rates are influenced by the discount rate. Lower rates encourage customers and companies to lend and spend. Increasing the discount rate is also contractionary because other interest rates are influenced by the discount rate. Higher levels prevent customers and companies from lending and spending. Reserve banks make adjustments to the discount rate

Reserve requirements are the portions of deposits that banks are required to keep in money, either in their vaults or on a reserve bank deposit. A reduction in reserve requirements is expanding as it increases the resources available for lending to customers and companies in the banking system. An rise in reserve requirements is contractionary as it decreases the resources available for lending to customers and companies in the banking system. The Governing Board has sole power over reserve requirement modifications. Reserve requirements are rarely changed by the Fed.

Open market operations, the buying and selling of U.S. government securities, has been a reliable tool. As we learned earlier, this tool is directed by the FOMC and carried out by the Federal Reserve Bank of New York.

Reserve interest is the latest and most frequently used instrument provided by Congress to the Fed following the 2007-2009 financial crisis. Excess reserves retained at Reserve Banks pay interest on reserves. Recall that banks are required by the Fed to maintain a proportion of their reserve deposits. Banks often keep additional resources on reserve in relation to these reserves. The current policy of paying interest on reserves allows the Fed to use interest as a monetary policy tool to influence bank lending