What are the tools that the Federal Reserve uses for monetary policy?

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pohnpei397 eNotes educator| Certified Educator

There are three tools that the Federal Reserve uses to conduct monetary policy.  These are reserve requirements, interest rates, and open market operations.

The first of these is the one that is used the least. When money is deposited in a bank, the bank keeps some of it as reserves and loans the rest out.  The Fed has the right to tell banks how much they must keep in reserves.  By changing the percentage that must be kept, the Fed can manipulate the money supply to some degree.

The second of these is the best-known.  The Fed often loans money to banks.  It can change the interest rate that it charges them when they borrow.  When it does, the banks often change their rates accordingly.  By lowering interest rates, then, the Fed can encourage people to borrow more money, thus increasing the money supply.

Finally, there are open market operations.  Here, the Fed is buying or selling government bonds.  When it buys bonds, it essentially prints money to buy them.  This new money increases the money supply.

Using these tools, the Fed can try to manipulate the money supply to keep the economy growing steadily, but not at an excessive rate.