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

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The goals of the monetary policy of the Federal Reserve are to maintain stable prices, maximize employment, and promote moderate long-term interest rates. The most important tools that the Fed uses for these purposes are open market operations, the discount rate, and reserve requirements.

The Fed's most commonly used tool is open market operations. This term refers to the buying and selling of US government securities by the Domestic Trading Desk of the Federal Reserve Bank of New York. These regular operations mainly affect the federal funds rate.

The discount rate is the interest rate at which banks can borrow funds directly from Federal Reserve Banks. Raising the discount rate decreases the amount of money in the system, while lowering the rate has the opposite effect of increasing the amount of money in the system.

Reserve requirements specify the minimum percentage of a bank's deposits that it must keep on reserve in the Fed. If the Fed wants less money in the system, it raises the reserve requirements, while if it wants more money in the system, it lowers the reserve requirements. The reserve requirements of various banks differ depending upon how much money they have on deposit.

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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.

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