What are the Traditional Tools of the Federal Reserve?
The Fed purchases government bonds (open market purchase)
If the Fed buys government bonds, the Fed gives reserves to the banks which means the banks may now make more loans, and the money supply increases.
The Fed sells government bonds (open market sale)
If the Fed sells government bonds, the Fed takes reserves from the banks. Therefore, the banks make fewer loans, and the money supply decreases.
Change the deposit rate
Since the deposit rate is the rate the Fed pays on reserves, and increase in the deposit rate would mean that banks are more willing to deposit reserves at the Fed. Therefore, the money supply decreases.
Change the discount rate
Since the discount rate is the interest rate the Fed charges banks who borrow from the Fed, and increase in the discount rate would cause banks to make fewer loans as they would be afraid of paying higher prices to the borrower. Therefore, the money supply decreases.
Change the Required Reserve
When the RR decreases, banks can make more loans, and the money supply increases. When RR increases, banks reduce the number of loans, and money supply decreases.
