The Banking System

Policy Tools of the Federal Reserve

The Fed has three main policy tools: open market operations, reserve requirements, and the discount rate.

The Federal Reserve has three main tools to execute monetary policy: open market operations, reserve requirements, and the discount rate. All three tools are used to affect the money supply level, which in turn affects economic activity.

The Federal Reserve primarily uses open markets operations to control the money supply. It can expand the money supply through the purchase and sale of U.S. government securities, such as Treasury bills. A security is a financial instrument representing monetary value, such as a stock, bond, or option. A Treasury bill (or T-bill) is a security issued by the U.S. Treasury Department representing a short-term debt obligation, with a relatively low interest rate but a maturity period of less than a year. The process through which the Federal Reserve buys Treasury bills to expand the money supply or sells Treasury bills to contract the money supply is known as an open market operation.

Open market operations add to the money supply in a multistep process. First, the Federal Reserve draws a check on itself for sufficient funds to purchase U.S. government securities from a dealer in such securities. Via electronic funds transfer, the Federal Reserve notifies the dealer's bank that the dealer's account should be credited with deposits in the amount of this check. The dealer may leave the funds in the account, withdraw them and deposit them in other banks, or withdraw and spend them, with the funds then going to the deposit account of whoever the dealer is buying goods or services from. This open market operation increases the money supply. Although no single bank may be holding the entirety of the deposits generated by the initial securities purchase, the overall amount created is still in the banking system. In addition, the overall excess reserves of the banking system have been increased by the amount of the securities purchase. The amount of the securities purchase is then available for further increase of the money supply via multiple deposit expansion.

Similarly, the Federal Reserve may reduce the money supply via the sale of government securities. Such sales remove from circulation the amount paid to the Federal Reserve for such securities, thus lessening the amount of excess reserves held by banks and contracting the size of the money supply.

The second policy tool at the Fed’s disposal is changing reserve requirements. If reserve requirements are raised, banks will need to hold a greater amount in reserves and the money supply would fall. If reserve requirements are lowered, banks will be required to hold less cash in vaults or on deposit at the Federal Reserve. The result is more lending, and the money supply increases. Small changes to the reserve requirements are made every year, but large changes are rarely executed because the result would be very disruptive to the economy.

If a bank has insufficient reserves, it can borrow funds from another bank with excess reserves. The interest rate on these loans is called the federal funds rate, or the rate charged for loans of excess reserves between banks to meet reserve requirements. In turn, the federal funds rate influences most of the other interest rates lenders charge. The Federal Reserve uses open market operations to target the federal funds rate. By purchasing securities, the Federal Reserve increases the cash reserves of commercial banks. This will lower the federal funds rate because banks' excess reserves will be higher and thus fewer banks will need to borrow. Conversely, when the Federal Reserve wants to raise interest rates and slow the economy, it can accomplish this through the sale of government securities, decreasing the amount of reserves commercial banks have available to lend, which causes those banks to increase the federal funds rate as the funds available to lend are scarcer and thus more valuable.

The third tool the Federal Reserve uses to affect the money supply is its direct control over the discount rate. The discount rate is the interest rate at which institutions can borrow money directly from the central bank, usually on a short-term basis, to meet temporary shortages of reserves. If the Federal Reserve raises the discount rate, the money supply will fall and market interest rates will rise because banks will reduce their borrowing and potentially call in loans to increase reserves. If lowered, the money supply will increase and market interest rates will fall. Typically, the discount rate is 0.50 percentage points higher than the federal funds rate.