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The Federal Reserve (FR) has three main tools to control the money supply in the economy: the discount rate, open market operations, and reserve requirements. The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee is responsible for open market operation (The Federal Reserve, n.d. a). As the primary goal of the FR is to balance the economy around the preset objectives, such as the 2% inflation rate, it manipulates the money supply to restore balance. Therefore, the FR can be expected to decrease the money supply if it believes the economy is overheated. Overheat implies that the overall demand for goods and services is higher than the capacity of the economy to produce them. Inflation can rise above the set corridor, and unemployment can fall to unsustainable levels. The FR intervenes to restore the balance and return the situation to standard.
As mentioned earlier, there are three main instruments that the FR possesses to pursue its policies, and each of them can be used to manipulate the money supply. Firstly, the FR can adjust interest rates in the economy by altering the interest rate charged to banks on loans they receive from their regional Federal Reserve Banks lending facility (Federal Reserve, n.d. b). This changes the cost of credit, either incentivizing or disincentivizing businesses and individuals to borrow and spend. Open market operations are based on the same logic; the FR sells bonds in the open market to extract money from the economy and buys them to inject more money into the economy. Finally, the FR can alter the reserve requirements for commercial banks, effectively controlling how much they can lend, either slowing or accelerating the loan issuance in the economy.
Finally, the FR intends to keep inflation under control at around 2-3%. All of the previously demonstrated tools are also used to affect inflation, as it correlates with the general economy overheating.
References
The Federal Reserve. (n.d. a). Federal Open Market Committee. Web.
The Federal Reserve. (n.d. b). Policy Tools. Web.
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