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What are the tools the Fed has available to influence the economy?

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The Federal Reserve (the Fed) is in charge of the country’s monetary policy.  It has three tools that it can use to carry out monetary policy and, thereby, to influence the economy.

The first, and least important, of these is the required reserve ratio (RRR).  When people deposit money in banks, the banks are required to keep a certain percentage of the deposits in reserves.  The percent they must keep is called the RRR.  When the Fed increases the RRR, banks must keep more money and loan less.  This reduces the supply of money in the economy and can slow the economy down.  Conversely, lowering the RRR can stimulate the economy.

The second tool is the most publically visible tool.  This is the Fed’s ability to change interest rates.  When interest rates are lowered, people and businesses are more able to borrow.  When they can borrow more easily, they can also consume or, in the case of businesses, invest more.  This stimulates the economy.  If the economy is overheated, the Fed is more likely to raise interest rates to cool it down.

Finally, there is the tool that the Fed engages in most frequently.  This is not typically done in the public eye.  This tool is called “open market operations” and it consists of buying and selling government securities.  If the Fed wants to increase the money supply, it buys governmental securities from banks.  Because it does so by “printing” money, it increases the money supply.  The Fed uses these transactions to fine tune the supply of money.

These are the Feds three tools of monetary policy.

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