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The Federal Reserve has three primary tools for affecting the reserves of depository institutions:
the Reserve Requirement, Discount Rate and Open Market Operations.

First, Reserve Requirement:

Reserve requirements are the amount of funds that a depository institution must hold
inreserve against specified deposit liabilities. Within limits specified by law, the Board of
Governors has sole authority over changes in reserve requirements.
For example: If the current 10% percent reserve requirement is demand to increase at 15%,
every depository institution will need to increase its required reserve.
Therefore, by simply increasing the reserve requirement, the Federal Reserve immediately
decreases banks capacity to grant loans. And vice versa, decreasing the reserve requirement,
increases the bank’s ability to lend.

Second, Discount Rate:

Discount Rate is the interest rate that the Federal Reserve charges banks when they borrow
reserves to meet temporary shortages in their required reserves.
A change in the cost of borrowing reserves alter banks’ willingness to borrow from the Federal
Reserve. An increase in the discount rate should discourage further borrowing and may cause
banks to retire debt owed the Federal Reserve.
For Example: There was a rapid increase of discount rate for 6% to 13% during inflation and
high interest rates, this is for the Federal Reserve restore more stable prices. As inflation and
interest rates subsided, the Federal Reserve lowered the discount rate to encourage economic

Third is Open Market Operations:

Open market operations involve the buying and selling of government securities. The term
“open market” means that the Fed doesn’t decide on its own which securities dealers it will do
business with on a particular day. Rather, the choice emerges from an “open market” in which
the various securities dealers that the Fed does business with – the primary dealers – compete
on the basis of price. Open market operations are flexible, and thus, the most frequently used
tool of monetary policy.
The Fed uses open market operations as its primary tool to influence the supply of bank
reserves. This tool consists of Federal Reserve purchases and sales of financial instruments,
usually securities issued EXAMPLE:
The Federal Reserve seeks to expand the supply of the money, it purchases securities. The
effect of this is:
- To increase the supply of money because demand deposits are increased
- To increase the reserves of the banking system.
The Federal Reserve seeks to contract the money supply, it sells government securities. The
effect is to
- Decrease the money supply, because demand deposits are decreased
- Decrease the total reserves of the banking system, because banks have fewer reserves
on deposit in the Federal Reserve.


Fiscal Policy is taxation, expenditures, and debt management by the federal government. It
may be used to purseue the economic goals of full employment, price stability and economic
growth. It also affects the supply of money and the capacity of the banking system to lend.

Deficit if the government expenditures exceed revenues, and this must be financed.
Surplus if government revenues exceeds the expenditures.

It is the financing of the deficit or disposing of the surplus that affect the supply of money and
capacity of the bank to lend.
If Federal government runs a deficit, it may obtain funds to finance by borrowing from the
1. General public
o Federal government issues securities to finance deficit, if the general public
purchases the securities, funds are transferred from the general public to the
treasury. When the Treasury pays for goods and services, the public’s bank
deposits are restored as the mone is transferred from the Treasury’s account to
the general public’s account. No change in money supply and reserves because
there is no change in the demand deposits or cash.
2. Banks
o Financed by the banks – the banks buy the government securities. The money
supply expanded but the capacity of the banks to lend decreased because
excess reserves are reduced.
3. The Federal Reserve
o The federal reserve buys the securities, the treasury account at the Fed is
increased. The Treasury spends these funds and payment of the commercial
banks. The federal reserve transfers funds from Treasury to the banks account.
Effects on money supply and ability of the banks to lend:
i. Total demand deposits rise when the public makes deposits
ii. Total reserves of the banks increased.
4. Foreign Investors
o Securities are sold abroad, when funds of the sale are deposited in domestic
banks, the banks’ reserves are increased.

If federal government runs a surplus it may retire debt held by:

1. General public
o More money is received than spent, but when the money is used to retire debt
held by the general public, the funds are returned to the private sector.
2. Banks
o The funds are returned to the bank’s system, which increases the bank’s capacity
to lend.
3. The Federal Reserve
o Both the money supply and the lending capacity of the banks are reduced. When
the funds are transferred to the Treasury they reduce the deposit liability of the
banks,This causes the money supply to decline and reduces the total reserves of
the banking system. The Reduction in the reserves decreases banks’ excess
reserves and, hence, decreases their ability to lend.
4. Foreign Investors
o The moneys flows out of the country reduces the domestic money supply and the
reserves of domestic banks.
Financing a government deficit or investing any government surplus can have an impact on the
money supply and commercial banks’ reserves and thus, have an impact on the supply and cost
of credit.


Inflation – a general increase in prices. Prices could also mean what produces must pay for the
plant and equipment, but when the word inflation is used, as the implication is that the prices of
consumer goods and services.

Deflation – General decline of prices. Lower prices aimply lower cost of goods sold and
increased profits for some individual firms. Lower prices, however, also imply decreased
revenues and profits for the other firm.

Recession – Period of atleast six months during which the economy experiences increased
unemployment and negative growth.