The government has two tools that it can use to try to influence the direction of the economy. Monetary policy, which is controlled by the Federal Reserve Board, determines the nation's money supply, while fiscal policy is controlled by the president and Congress and determines government spending and taxation.
TOOLS OF THE FEDERAL RESERVE BOARD
The Federal Reserve Board will try to steer the economy through the business cycle by adjusting the level of money supply and interest rates. The Fed may:
• Change the reserve requirement for member banks
• Change the discount rate charged to member banks
• Set target rates for federal fund loans
• Buy and sell U.S. government securities through open-market operations
• Change the amount of money in circulation
• Use moral suasion
Member banks must keep a percentage of their depositors' assets in an account with the Federal Reserve. This is known as the reserve requirement. The reserve requirement is intended to ensure that all banks maintain a certain level of liquidity. Banks are in business to earn a profit by lending money. As the bank accepts accounts from depositors, it pays them interest on their money. The bank, in turn, takes the depositors' money and loans it out at higher rates, earning the difference. If the Fed wanted to stimulate the economy, it might reduce the reserve requirement for the banks, which would allow the banks to lend more. By making more money available to borrowers, interest rates will fall and, therefore, demand will increase, helping to stimulate the economy. If the Fed wanted to slow down the economy, it might increase the reserve requirement. The increased requirement would make less money available to borrowers. Interest rates would rise as a result and the demand for goods and services would slow down. Changing the reserve requirement is the least-used Fed tool.