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The monetary policy of the US Federal Reserve and the country’s central bank require some important tools to control the supply of money available in its economy. These tools include open market operations, discount rates and fractional reserves and many more.
The open market operations are one of the subtle tools to increase money supply. The Fed uses this tool to buy treasury securities belonging to the government which in turn can trigger a gentle increase in the supply of money in small percentages over a period of time. Treasury securities consist of treasury bonds with a life span of a decade, while treasury notes have a life span of two to ten years. There are Treasury bills that mature in one year or less, but these are the most favored instrument used by the Fed.
The next tool that the Federal Reserve uses to pump in money into the economy is through the discount rates. Whenever banks require money for their day-to-day activities, they borrow it from the Fed. These loans carry a rate of interest which is called discount rates. The Fed tweaks the discount rates and in doing so sends out a clear message if it wants to either increase or decrease money supply. When the Fed decreases the discount rate, banks are encouraged to borrow money from it. The borrowed money is then lent to the businesses to expand, or towards housing loans resulting in increased money supply in the economy.
The Federal Reserve in America adopts another tool called fractional reserves to increase money supply. At any point of time, all depository institutions including banks in the country are required to keep some percentage of their check accounts that are interest-bearing and non-interest bearing as reserves with the Fed. In other words, the required reserves are actually a fraction of the deposits. This is tweaked whenever it is required to pump in more money into the economy. The Fed seldom uses these changes in this system which has more impact in the market.
One of the popular tools to increase money supply is the Fed funds rate. This is the rate of interest that banks charge each other for overnight loans of reserve balances. A change in the Fed funds rates directly impacts the short-term interest rates like bank deposits, credit card interest rates, bank loans and the adjustable-rate mortgages. To increase money supply the Federal Reserve will decrease the Fed funds rate so that banks could lend more. This results in an overall stimulation of the economy by expansions of businesses, home loans getting cheaper, and creating an increase in demand for loans.
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