Federal reserve controls the money supply through reserve requirements, discount rate and open market operations. Reserve requirement is the percentage of deposits that banks have to keep as reserve in their vaults or with federal reserve district bank. Discount rate refers to the rate of interest charged by Federal Reserve (Fed.) to member commercial banks. Open market operations refers to the buying and selling of government securities undertaken by Fed. to directly impact the money supply. (Pride, Hudges & Kapoor, 2008)
2: In an economy that is undergoing rapid growth the threat of inflation is imminent. Therefore, Federal Reserve would like to decrease the money supply in circulation to control the economy. To do this the Federal reserve would increase the reserve requirements as this would increase the money restricted from circulation in form of reserves with the banks. Banks would lend fewer advances and money supply will be decreased. The interest rates will increase due to increased demand of money, investment and credit backed consumption will be curtailed and economy would slow down. It would also increase the discount rate as this will make borrowing from Fed. expensive, bank’s will also charge higher interest rates, advance fewer loans and decrease money supply. This would lessen the consumption and investment in economy and slow it down. It could also sell securities in the money market through open market operations. This would decrease the money supply, increase interest rates, decrease investment, decrease aggregate demand and decrease GDP. (Pride, Hudges & Kapoor, 2008)
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