Monetary Policy tools:
The Fed can use the following tools to influence the money supply.
1. Open Market Operation: The Fed can affect the money supply by buying or selling U.S. government securities, using open market operations. When the Fed purchases a government security from the public, it does so with money that did not exist in the system. Thus, bank reserves will rise, increasing the money supply.
2. The Required-Reserve Ratio (r): The Fed can influence money supply by changing this ratio. This ratio specified the amount banks must hold as reserves on all deposits and limits the amount that banks may lend out. If the Fed increases the reserve ratio, the deposit and money multiplier will be smaller, thereby further limiting the amount by which banks may expand the money supply.
3. Discount Rate: Banks will borrow funds when needed. When the banks borrow from the Fed, they pay an interest rate called the Discount rate. When the discount rate is raised, banks will have less incentive to borrow, thus lowering the money supply in the system.
When the economy is in an inflationary gap, the Fed will adopt a contractionary monetary policy to decrease the money supply in the market by selling securities, raising the reserve rate, and/or increasing the discount rate. When the economy is in recessionary gap, the Fed will adopt expansionary monetary policy to increase money supply in the market by buying securities, lowering the reserve rate, and/or decreasing the discount rate.