Description                                  
In this presentation, the narrator describes how the Fed can effect the money supply through the use of varying monetary policy tools. 

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To see how the Federal Reserve conducts monetary policy, we need only look at the Fed's balance sheet. 

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The great majority of the Fed's assets are in U.S. government securities. In this lesson we will see how the Fed can effect the money supply through varying its stock of government securities. 

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The Federal Reserve also makes overnight loans to commercial banks. These loans, called "discount loans", are also Fed assets. The interest rate paid on these loans is called the "discount rate". 

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By far, the largest Fed liability are currency notes in circulation. Federal Reserve notes, such as the bills that you hold in your pocket, are actually liabilities of the Federal Reserve. 

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The Fed also holds the required reserve deposits of commercial banks, which is another large liability. 

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The Federal Reserve has three general policy tools that it uses to conduct monetary policy. 

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The first, and most often used tool, is open market operations, which entail the Fed's buying and selling of government securities from and to commercial banks. 

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The discount rate is another important tool at the disposal of the Federal Reserve. The Fed lowers the discount rate when it wants to encourage banks to borrow and raises the discount rate when it wants to discourage borrowing. 

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The reserve requirement ratio is the tool least used by the Fed but it is a very powerful tool that can have unpredictable and dramatic effects on the supply of money. 

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Open market operations are under the direct control of the federal open market committee. This committee meets every six weeks to set policy on the buying and selling of government securities. 

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As revealed in the Federal Reserve's balance sheet, the Fed holds a large volume of government securities and if we examine a typical commercial bank's balance sheet, we find that it also holds a large volume of government securities. 

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If the Fed purchases government securities from a commercial bank, it reduces the bank's holdings of government securities and increases the bank's reserves. If none of these reserves are needed to satisfy reserve requirements, the bank is free to use them to create earning assets, such as loans. In making loans, the commercial banking system can create money through the money multiplier process. 

Narrator: 
If the Fed sells securities to commercial banks, the banking system loses reserves and is constrained in its ability to create earning assets. If a particular bank loses required reserves through this process, it must borrow reserves from another bank, borrow from the Fed, or shrink its asset base, thus freeing up reserves. If the bank is forced to obtain required reserves through the reduction in earning assets; this reduction may cause a reduction in the demand deposit base through the money multiplier process and ultimately may reduce the supply of money. 

Narrator: 
There are at least four reasons why open market operations is the Fed's most important monetary policy tool: open market operations are implemented at the discretion of the Fed, open market operations are easily reversible, open market sales and purchases can be undertaken in any magnitude, and open market operations can be implemented quickly.  

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The required reserve ratio is a powerful tool that can dramatically effect the money supply. A small change in the required reserve ratio has a significant effect on the multiplier. The table of values demonstrates this sensitivity. 

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In practice, the Fed seldom changes the required reserve ratio. It is a crude instrument, neither subtle nor adjustable and its use is disruptive to the banking system. Also, it is regulatory in nature rather than market-based. 

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When commercial banks borrow money from the Federal Reserve, the interest rate on these loans is called the discount rate and this rate is set by the Fed. From a policy perspective, discount lending serves two different functions. First, the Fed acts as a lender of last resort to commercial banks. But, the real power of the discount rate is in the signal that the Fed sends regarding its willingness to increase or decrease the supply of money. 

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