The Federal Reserve Board has a variety of monetary tools available to it to influence the economy. Identify and define the most commonly used mechanism of monetary policy and one additional tool of your choice. Discuss the effect of each of these tools on the relevant parties.

What will be an ideal response?

The most commonly used mechanism is the open-market operation. In open-market operations, the Federal Reserve enters the money markets to buy or sell securities issued by the federal government. If the Fed wishes to reduce the supply of money, it will attempt to sell securities, exchanging bonds for cash that was in circulation. If it wants to expand the money supply, it purchases securities on the market, exchanging money for bonds. Other monetary tools include the discount rate and federal funds rate and bank reserve requirements. The discount rate and the federal funds rate are the rates of interest at which member banks can borrow money from the Federal Reserve or from one another to cover shortages in their required reserves. The Federal Reserve Board can change the reserve requirement. Member banks of the Federal Reserve System must keep on deposit at the Federal Reserve banks a percentage of the total amount they have out in loans, normally around 10%. If the Fed raises the reserve requirement from 10% to 12.5%, then for each dollar a bank had out in loans before the change, it can lend only 75 cents.