cCentral banks use tools like open market operations, the selling and buying of securities in the open market to target and/or influence the money supply and interest rates. In the U.S, the Federal Reserve System (Fed) also uses other monetary tools such as the reserve requirement and the discount rate to influence the interest rate and money supply.
This essay looks at why the simultaneous targeting of the money supply and interest rate and why it is sometimes difficult to achieve, and also examines how central banks intervene in foreign exchange markets and finally, this essay looks at what the Bretton Woods Agreement did to the ability of foreign exchange rates to fluctuate freely.
As noted earlier, central banks (in this case, the Fed) usually use open market operations to influence the interest rate and money supply in the U.S. By selling government bonds, the Fed reduces reserves available to banks for lending, so the money supply shrinks and interest rates rises. By buying government bonds, the Fed will increase reserves available to banks for lending, so money supply will increase and interest rates will fall.
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If the Fed goes ahead and maintains an interest rate target while money demand changes, it will have to adjust its money supply and hence, miss its money supply target. On the other hand, if the Fed maintains a money supply target while money demand changes, it will have to let interest rate change and hence, miss the interest rate target.
Money supply influences the interest rate i.e. if there is less money in circulation, interest rates will be higher and vice-versa. Theoretically, the Fed can only control both the interest rate and money supply if there are strict limits on capital investments (lending and investments) which would be almost impossible to