Standard 1Understand the fundamental

concepts relevant to the development of a market

economy

SS.912.E.1.11SS.912.E.1.11Explain how the Federal Reserve uses the Explain how the Federal Reserve uses the tools of monetary policy (discount rate, tools of monetary policy (discount rate,

reserve requirement, open market reserve requirement, open market operations) to promote price stability, full operations) to promote price stability, full

employment, and economic growth employment, and economic growth

Three tools of the Fed to control the money supply:Three tools of the Fed to control the money supply:

1)1) Reserve requirementsReserve requirements

The US banking system operates as a fractional The US banking system operates as a fractional reserve system- banks must keep a portion reserve system- banks must keep a portion (currently 10% for most banks) of their total (currently 10% for most banks) of their total deposit value amount as either vault cash or deposit value amount as either vault cash or required reserves at a Fed branchrequired reserves at a Fed branch

Required reserves cannot be loaned out; they are Required reserves cannot be loaned out; they are held to “protect” banks from runs by depositorsheld to “protect” banks from runs by depositors

Each bank conducts an accounting at the end of Each bank conducts an accounting at the end of each business day to calculate required each business day to calculate required reservesreserves

Video: It’s a Wonderful LifeVideo: It’s a Wonderful Life

Three tools of the Fed to control the money supply:Three tools of the Fed to control the money supply:

1)1) Reserve requirementsReserve requirements

If the Fed decreases reserve requirements If the Fed decreases reserve requirements (i.e. lowers from 10%), then it engages in (i.e. lowers from 10%), then it engages in expansionary monetary policy because expansionary monetary policy because more reserves are able to be loaned out more reserves are able to be loaned out

If the Fed increases reserve requirements If the Fed increases reserve requirements (i.e. raises from 10%), then it engages in (i.e. raises from 10%), then it engages in restrictive monetary policy because fewer restrictive monetary policy because fewer reserves are able to be loaned outreserves are able to be loaned out

Three tools of the Fed to control the money supply:Three tools of the Fed to control the money supply:

2)2) Open Market OperationsOpen Market OperationsThe FOMC in NY buys and sells bonds (i.e. The FOMC in NY buys and sells bonds (i.e.

securities)securities)If the Fed buys directly from a member bank, it If the Fed buys directly from a member bank, it

“pays” the bank with excess reserves“pays” the bank with excess reservesIf the Fed buys from someone else, the effect is If the Fed buys from someone else, the effect is

the same because the cash payment will the same because the cash payment will usually end up as a new deposit at a bankusually end up as a new deposit at a bank

If the Fed buys bonds, then it engages in If the Fed buys bonds, then it engages in expansionary monetary policy because more expansionary monetary policy because more excess reserves are able to be loaned out excess reserves are able to be loaned out

If the Fed sells bonds, then it engages in restrictive If the Fed sells bonds, then it engages in restrictive monetary policy because fewer excess monetary policy because fewer excess reserves are able to be loaned outreserves are able to be loaned out

Three tools of the Fed to control the money supply:Three tools of the Fed to control the money supply:

3)3) Discount rateDiscount rate

When banks borrow and lend to each other to When banks borrow and lend to each other to meet required reserves, they do so in the meet required reserves, they do so in the federal funds market and use the federal funds federal funds market and use the federal funds interest rate to make transactionsinterest rate to make transactions

Even though the Fed is not directly involved in Even though the Fed is not directly involved in these transactions, it can influence the fed these transactions, it can influence the fed funds rate by making excess reserves more funds rate by making excess reserves more scarce or more plentifulscarce or more plentiful

See S&D analysis in the marketSee S&D analysis in the market

Graph:Graph:

Three tools of the Fed to control the money supply:Three tools of the Fed to control the money supply:

3)3) Discount rateDiscount rate

The Fed prefers member banks to borrow from the The Fed prefers member banks to borrow from the fed funds market. If a bank cannot borrow the fed funds market. If a bank cannot borrow the necessary funds to meet required reserves, it necessary funds to meet required reserves, it can turn to the Fedcan turn to the Fed

Hence the term “lender of last resort”Hence the term “lender of last resort”

If a bank borrows from the Fed, the bank pays the If a bank borrows from the Fed, the bank pays the discount rate which is typically 0.5 to 1% discount rate which is typically 0.5 to 1% higher than the fed funds ratehigher than the fed funds rate

Even today, there is a large negative stigma for a Even today, there is a large negative stigma for a bank to borrow from the discount windowbank to borrow from the discount window

Three tools of the Fed to control the money supply:Three tools of the Fed to control the money supply:

3)3) Discount rateDiscount rate

If the Fed lowers the discount rate, then it engages If the Fed lowers the discount rate, then it engages in expansionary monetary policy because in expansionary monetary policy because more excess reserves will be loaned to more excess reserves will be loaned to member banksmember banks

If the Fed raises the discount rate, then it engages If the Fed raises the discount rate, then it engages in restrictive monetary policy because fewer in restrictive monetary policy because fewer excess reserves will be loaned to member excess reserves will be loaned to member banksbanks

Addendum: Recent critical changes in the Addendum: Recent critical changes in the way the Fed conducts monetary policyway the Fed conducts monetary policy

Prior to 2008, the Fed did not pay Prior to 2008, the Fed did not pay interest on required or excess reservesinterest on required or excess reservesThe Financial Services Regulatory Relief Act of 2006 The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008.  the effective date to October 1, 2008.  Employing the accelerated authority, the Board has Employing the accelerated authority, the Board has approved a rule to amend its Regulation D (Reserve approved a rule to amend its Regulation D (Reserve Requirements of Depository Institutions) to direct the Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve Federal Reserve Banks to pay interest on required reserve balances (that is, balances held to satisfy depository balances (that is, balances held to satisfy depository institutions' reserve requirements) and on excess balances institutions' reserve requirements) and on excess balances (balances held in excess of required reserve balances and (balances held in excess of required reserve balances and clearing balances).  clearing balances). 

What do you think happened to What do you think happened to excess reserves?excess reserves?

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100

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300

400

500

600

700

800

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Bill

ions

of

Dol

lars

i

Excess Reserves of Depository Institutions, 1980 to the present

Recent Changes in Monetary PolicyRecent Changes in Monetary Policy

1)1) Changes in Open Market OperationsChanges in Open Market Operations

a)a) Previously only bought and sold U.S. Treasury Previously only bought and sold U.S. Treasury BondsBonds

b)b) Now buy and sell broad range of assetsNow buy and sell broad range of assets Mortgage-backed securities, commercial paper, Mortgage-backed securities, commercial paper,

corporate bondscorporate bonds Has same effect on money supplyHas same effect on money supply

2)2) Extension of LoansExtension of Loans

a)a) Fed previously gave loans only to member banks for Fed previously gave loans only to member banks for a short periods of timea short periods of time

b)b) Fed now gives loans to non-bank financial Fed now gives loans to non-bank financial institutions for long time periodsinstitutions for long time periods

rev20090317 Fed Operations and Monetary Policy

Federal Reserve Assets$billions

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600

800

1,000

1,200

1,400

1,600

1,800

Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08

Treasuries

TAF + Discount Window

Repos

Other (currency swaps)

AMLF

PDCF

AIG

ML

Agency

Activity in Federal Reserve lending facilities has risen sharply.

It’s all about providing LIQUIDITY to keep the credit markets, and by extension the economy, from freezing up.

AMLF is combination of Asset-Backed Commerical Paper, Money market mutual funds, and Liquidity FacilityPDCF is Primary Dealer Credit FacilityAIG is American Insurance Group financial rescueML is Maiden Lane (Bear Stearns financial rescue)Agency is short-term debt issued by Fannie Mae and Freddie MacTAF is Term Auction FacilityRepos are collaterilized loans