16.4 The Fed’s Tools of Money Currency
16.4 a. How the Fed Influences the Quantity of Reserves
The Fed primarily manages the growth of bank reserves and money supply in order to allow a stable expansion of the economy. To implement its primary task of controlling money supply, there are three main tools the Fed uses to change bank reserves:
A change in reserve requirements: The reserve ratio is the percentage of reserves a bank is required to hold against deposits. A decrease in the ratio will allow the bank to lend more, thereby increasing the supply of money. An increase in the ratio will have the opposite effect.
A change in the discount rate: The discount rate is the interest rate that the central bank charges commercial banks that need to borrow additional reserves. It is an administered interest rate set by the Fed, not a market rate; therefore, much of its importance stems from the signal the Fed is sending to the financial markets (if it’s low, the Fed wants to encourage spending and vice versa).
Open-market operations: Open-market operations consist of the buying and selling of government securities by the Fed. If the Fed buys back issued securities (such as Treasury bills) from large banks and securities dealers, it increases the money supply in the hands of the public. Conversely, the money supply decreases when the Fed sells a security.
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Fed’s Tools [25]
16.4 b. How the Fed Influences the Reserve Ratio
Reserve Requirements: Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Within limits specified by law, the Board of Governors has sole authority over changes in reserve requirements. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks [22].
Paying Interest on Reserves: Starting from 2008, the Fed pays interest to depository institutions on the reserves they are required to hold against their deposit liabilities. The failure of high profile U.S. financial institutions in September 2008 caused a great degree of instability in the financial system. Consistent with its role as a lender of last resort, the Fed provided unprecedented amounts of liquidity to the financial system. Once the Fed was authorized to pay interest on reserves, the relationship between the levels of required reserves and excess reserves changed dramatically. The Fed’s new authority gave policymakers another tool to use during the financial crisis. Paying interest on reserves allowed the Fed to increase the level of reserves and still maintain control of the federal funds rate. As the Board’s website states, “Paying interest on excess balances should help to establish a lower bound on the federal funds rate.” [23].
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Banks earn Interest on Reserves [24]
16.4 c. Problems in Controlling the Money Supply
The Federal Reserve does not control the amount of money that consumers choose to deposit in banks [26].
Example: The more money that households deposit, the more reserves the banks have, and the more money the banking system can create. The less money that households deposit, the smaller the amount of reserves banks have, and the less money the banking system can create [26].
The Fed does not control the amount that bankers choose to lend. The amount of money created by the banking system depends on loans being made [26].
Example: If banks choose to hold onto a greater level of reserves than required by the Fed (called excess reserves), the money supply will fall [26].
How the Federal Reserve Controls Money Supply [27]
16.4 d. The Federal Funds Rate
The federal funds rate is the rate at which depository institutions (banks) lend reserve balances to other banks on an overnight basis [28].
Example: When a bank is unable to meet reserve requirements, it may get a Federal Funds loan. These loans are unsecured and are for very short periods (typically overnight). An increase in the federal funds rate discourages banks from borrowing to meet reserve requirements, which encourages them to build up reserves and lend out less money [29].
Federal Funds Rate [30]
