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Monetary Policy
The Federal Reserve Bank constitutes the central banks in the United States that has three tools of monetary policy they can control the money supply to influence interest rates and total level of spending in the economy to maintain price-level stability, full employment and economic growth. They are Open-market operations, the reserve ratio and the discount rate. The Fed's Open-market operations consist of the buying of government bonds from, or the selling of government bonds to, commercial banks and the public. Open-market operations are Fed's most important instrument for influencing the money supply (McConnell-Brue, 2004, p.270). When Federal Reserve purchase government bonds or securities from commercial banks, increase the reserves of the commercial banks, then increases the lending ability of the commercial banks and they sell the securities, decrease the reserves of the commercial banks. Buying bonds increases the reserve banks will hold, this enables banks to lend more money and they can reduce lower interest rates while selling bonds effect higher interest rates and lower bond prices in the market.
Another tool is the reserve ratio that controls a power technique of money supply. The reserve ratio is a percentage of deposits that commercial bank holds as reserves. The Fed can mandate the reserve ratio in order to influence the ability of commercial banks to lend. Raising the reserve ratio can lead to a decrease in excess reserve and increase the amount of required reserves bank must keep. Lowering the reserve ratio can occur the opposite; increase excess reserves and enhances the ability of banks to create new money by lending. Reserve ratio affects the money-creat ...