THE FED’S TOOLS OF MONETARY CONTROL

As we have already discussed, the Federal Reserve is responsible for.controlling the supply of money in the economy. Now that we understand how fractional-reserve banking works, we are in a better position to under stand how the Fed carries out this job. Because banks create money in a system of fractional-reserve banking, the Fed’s control of the money supply is indirect. When the Fed decides to change the money supply, it must consider how its actions will work through the banking system. The Fed has three tools in its monetary toolbox: open-market operations, reserve requirements, and the discount rate. Let’s discuss how the Fed uses each of these tools.