What should the feds do with the three policy tools?

Answer 1

The United States Federal Reserve is responsible for the country's monetary policy; they have three policy tools with which they can influence the amount that private banks hold (and thus, can loan out). The most common tool used is open market operations (OMOs). Open market operations are the purchases and sales of U.S. Treasury bonds. If the Fed wants to curb inflation with OMOs, they would purchase bonds from private banks (or in less common cases, from individuals); by purchasing bonds, they increase the money supply in the economy, which lowers the nominal interest rate (refer to money market graph for visual). If there is deflation, the Fed will want to sell bonds to banks (decrease the money supply). Another policy tool of the Fed is changing the discount rate. The discount rate is what the Federal Bank charges private banks for taking out loans at the discount window. This is usually just a symbolic gesture, and a decrease in the discount rate is a common action when there is inflation. The least used policy tool is changing the reserve ratio. This is the amount (a percentage) the Federal Reserve requires private banks to hold within their federal accounts by the end of the day. Lowering the reserve ratio makes it easier for banks to loan out more, and thus, increases the money supply (easy money policy to curb inflation).