The Federal Reserve Bank can control the money supply by controlling the amount of bank reserves. It has three tools at its disposal: the conduct of open market operations, and changes in the reserve ratio and the discount rate. Monetary policy consists of deliberate changes in the money supply to influence interest rates and thereby the level of aggregate spending and employment in the economy.

The three graphs in the window illustrate the cause-effect chain that links changes in the money supply, the interest rate, investment spending, and aggregate demand. The Fed can, through its control of the money supply, influence aggregate demand, thereby influencing equilibrium real GDP and the price level. To use the graphs, increase or decrease the money supply by dragging the green triangle at the base of the S_m curve. The other two graphs track the interest-rate induced changes in investment spending and aggregate demand. Click on the Price Adjustment button to see the impact of changes in the money supply on equilibrium GDP and the price level.

1. Suppose the Fed buys bonds on the open market in sufficient quantities to increase the money supply by $600 billion. What impact will this have on the interest rate, investment spending, real GDP, and the price level?
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2. Suppose the Fed increases the discount rate and sells a sufficient number of bonds to reduce the money supply by $300 billion. What impact will this have on the interest rate, investment spending, real GDP, and the price level?
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3. Experiment on your own. How might the Fed respond to a problem of substantial unemployment? How might the Fed respond to a problem of high inflation? Can the Fed fight both inflation and unemployment at the same time?
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