Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal. The rest is invested in illiquid assets, such as mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of funds that can be loaned. This acts as a change in the money supply.
Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can only directly set the discount rate. It does this by engaging in open market operations and alters the federal funds rate. This rate has some effect on other market interest rates, but there is no direct relationship. In other nations, the monetary authority may be able to mandate specific interest rates on loans and other financial assets. Therefore, by altering the interest rates under its control, a monetary authority can affect the money supply.
If an economy is growing too rapidly, then the Federal Reserve may decrease the money supply by selling government bonds. This will increase inflation and increase interest rates in the economy. Making prices higher and decreasing consumer spending.
If an economy is in recession, then the Federal Reserve would purchase government bonds. This will increase the money supply and reduce interest rates. It will also decrease inflation and unemployment. It will also increase the... [continues]
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