The Federal Reserve uses various monetary tools to alter the money supply in the economy indirectly through the banking system. The three major instruments used include: open market operations, reserve requirements, and the discount rate (Mankiw, 2007). Open market operations involves the Fed buying or selling government bonds to the public with the aim of changing the quantity of the circulating currency. Reserve requirements sets a statutory minimum that banks must hold against customer deposits, while the discount rate is the interest rate the Fed charges banks on loans issued.
The monetary policy tools can be divided into contractionary or expansionary instruments. The Fed uses expansionary policies such as buying bonds from the public to increase money supply, reducing the reserve requirement, and lowering the discount rate to stimulate the economy. On the other hand, contractionary tools are meant to slow down the economy and mitigate against inflation. These instruments are; sale of government bonds, raising of the reserve requirements, and charging a high discount rate (Mankiw, 2007).
Depending on the state of the economy expansionary and contractionary policies have their pros and cons. During a period of depression, expansionary monetary policies are effective in stimulating the economy resulting in a reduction in unemployment on the other hand contractionary policies would plunge the economy into further trouble. For the case of a recession, money is added to the economy through expansionary tools to spur growth. The fed uses contractionary monetary instruments to curb inflation, which would affect the economy negatively. During robust economic growth the Fed balances the use of monetary policy tools to ensure inflation remains normal and the economy does not go into a depression.
All tools have their strengths and weaknesses. However, open market operations has a more direct effect in the economy compared to the others and might be more appropriate in today’s economy.
References
Mankiw, NG 2007, Macroeconomics. New York: Worth Publishers.
