Sunday, July 29, 2012

Please explain if there are any other tools, besides interest rates, that can be used to influence the supply of money, inflation, and deflation....

There are two other tools that a central bank like the Federal Reserve can use to try to influence the money supply. When the Fed influences the supply of money, it is also influencing the levels of inflation or deflation. The other two tools the Fed can use are reserve requirements and open market operations.


Reserve requirements have to do with banks and lending. When banks receive money as deposits, they do not simply keep that money in their vaults.  Instead, they lend it out, thus making money for themselves. However, the banks are not allowed to loan out all the money they take in.  They must keep a certain percentage in their own hands. This percentage is the required reserve. The Fed can increase the reserve requirement if it wants to lower the supply of money (if inflation is too high) and decrease it if it wants to increase the supply (if there is a danger of deflation).


Open market operations are when the Fed buys and sells government securities.  When the Fed sells government securities it gives the securities to banks in return for money.  This takes money out of circulation, thus reducing the money supply (making inflation less likely).  When the Fed buys government securities, it gives the banks money and gets the securities bank. Now the banks have more money and the supply of money increases (this makes deflation less likely).


Your question says that the Fed uses interest rate manipulation more than these other tools.  This is not true.  The Fed rarely changes reserve requirements.  This is because that is too strong of a tool.  It is hard for banks to adjust to this and it is hard to carefully calibrate how much of an impact it will have on the money supply.   While the Fed rarely changes reserve requirements, it often engages in open market operations.  This is the tool that it uses far more than any other (see link below). This is because open market operations can change the supply of money by small amounts on a day-to-day basis, thus giving the Fed the ability to affect the supply of money much more precisely than it can with either of the other tools.

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