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Kavan Choksi / カヴァン・チョクシ Sheds Light on The Fed's Tools for Influencing the Economy

 


The Federal Reserve (The Fed) is responsible for maintaining a stable and growing economy in the U.S. through price stability and full employment. As Kavan Choksi / カヴァン・チョクシ says, historically the Fed has achieved these goals by adjusting reserve requirements, engaging in open market operations (OMO) and manipulating short-term interest rates.  The Fed also had developed tools to fight economic crises that emerged during the 2007 subprime crisis.

Kavan Choksi / カヴァン・チョクシ talks about the tools used by the Fed to influence the United States economy

The very first tool used by the Fed to influence the economy is the manipulation of short-term interest rates. This tool, in fact, is used by central banks around the world. It involves raising and lowering interest rates for the purpose of slowing or spurring economic activity and controlling inflation. It becomes less lucrative to save and cheaper to borrow money when interest rates are low, and encourages individuals and businesses to spend more as well. More funds are borrowed, savings decline, and more money is spent as interest rates decline.  As borrowing increases, so does the total supply of money in the economy increases.

Lower interest rates, however, may also increase inflation, as the total supply of goods and services is essentially finite in the short term. When more dollars are chasing that finite set of products, prices invariably go up.  If inflation gets too high, then the economy may experience a significant negative impact.

Open market operations (OMO) are another major tool available to the Fed, and involve the Fed buying or selling Treasury bonds in the open market. It involves the Fed buying or selling Treasury bonds in the open market. OMO can impact interest rates, as well as increase or decrease the total supply of money. By swapping out bonds in exchange for cash to the general public when it buys bonds in the open market, the Fed can increase the money supply in the economy. It lowers the money supply by removing cash from the economy in exchange for bonds, as it sells bonds.

As Kavan Choksi / カヴァン・チョクシ says, the Federal Reserve may even adjust the reserve requirements of the banks. This essentially determines the level of reserves a bank must hold in comparison to the deposit liabilities specified. On the basis of the required reserve ratio, the bank may hold a certain percentage of the specified deposits in vault cash or deposits with the Federal Reserve banks.

Influence on market perceptions is the final tool used by the Fed to affect markets. This is somewhat a bit more complicated as it relies on the concept of influencing the perceptions of the investors, which is not always easy due to the transparency of the United States economy. Doing so may involve any type of public announcement from the Fed regarding the economy. The Fed may say that the economy is growing too fast and hence it is worried about inflation, which would logically mean that an interest rate increase is needed to cool the economy.

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