Methods that FED can use to make money

Question

What are the four methods that FED can use to make money? What are the most powerful one and what technique the FED to create a gradual easing of the money supply either created or destroyed most seldom uses?

Answer 1

The four ways in which FED can create money are

• Open Market Operations purchase: This refers to the Federal Bank purchasing government securities in the open market, so that they can increase the reserves of the banks, which can in turn use these reserves to make loans, thus creating new money in the economy,

• Decrease in Required Reserve ratio: It is mandatory for all banks to keep a certain amount of deposits with the Federal Bank as a measure of safety. On reduction of these requirements, banks can keep less with Fed and lend more, thus creating money in the economy,

• Decrease in interest/discount rates: When interest rates are lowered, it leads to money being cheaply available, which will hence push banks to lend more or people to obtain more loans, thus improving money supply in the economy and

• Quantitative easing: This is the creating of a considerable amount of money by the Fed through its purchase of assets such as long-term government bonds, company bonds, stocks, asset backed securities, etc that it normally does not buy. This improves bank reserves, which are used to lend loans, thus creating money in the economy.

In reality, changing the reserve ratio is a heavy-handed approach and hence it is an infrequently used approach. Quantitative easing is also employed only when lowering the discount rate is not effective any more as the interest rates have already been reduced to or very near to zero percent. The Fed normally uses lowering the discount rate to gradual ease the money supply, after which it utilizes the open market operations approach. Thus the Fed most often uses the discount rate change approach. Only if this approach does not function as expected, the other methods are employed.