The Federal Reserve System

The Federal Reserve controls the economy of the United States through a variety of tools. They use these tools to shape the monetary policy of the United States in order to promote economic growth and reduce the rate of inflation and the unemployment rate. By adjusting these tools, the Fed is able to control the amount of money in the supply. By controlling the amount of money, the Fed can affect the macro-economic indicators and steer the economy away from runaway inflation or a recession.

The Federal Reserve uses three main tools in order to control the money supply. The first tool is open-market operations. These operations consist of the buying and selling of government bonds to commercial banks and the public. Open-market operations are the most important tool that the Fed can use to influence the money supply. By buying bonds from the open market, the Federal Reserve increases the reserves of commercial banks which in turn will increase the overall money supply in the country. The opposite is true if the Fed sells bonds on the open market. By doing so, the Fed reduces the reserves of banks and, in turn, takes money out of the system. By being able to control how much money the commercial banks can lend, the Fed has a very powerful tool to adjust the economy.

The second tool the Federal Reserve uses is the adjustment of the reserve ratio. The reserve ratio is the ratio of the required reserves the commercial bank must keep to the bank's own outstanding checkable-deposit liabilities. By raising and lowering the ratio, the Fed can control how much the commercial banks can lend. For example, if the Fed lowers the reserve ratio, commercial banks will now have more excess reserves allowing them to lend more money to businesses or individuals. Vice-versa, by increasing the ratio, the Fed forces the banks to lend less money due to having smaller excess reserves.

Finally, the last tool the Fed can use is to adjust the discount rate. The discount rate is the interest rate at which the Federal Reserve charges commercial banks for a loan. By issuing the loan to the commercial bank, the Fed increases the reserves of the borrowing bank which allows them to issue credit to the public. Depending on which way the Fed adjusts the rate either encourages or discourages commercial banks from obtaining a loan. A decrease in the rate encourages banks to obtain loans from the Federal Reserve Banks. With the additional reserves, the banks can lend more to the public, also increasing the money supply. The opposite happens if the Fed decreases the discount rate.