The Federal Reserve (the Fed) has a big job to do as it tries to accomplish the goals the U.S. Congress has given it. But how exactly does the Fed go about accomplishing its goals? What tools does the Fed have at its disposal to affect monetary policy?
[VIDEO] The Monetary Policy Tools of the Federal Reserve
Congress—along with giving the Fed goals that it has to accomplish—gave the Fed tools and authorities to enable it to meet its goals. Let’s take a look at the following primary tools the Fed uses to affect monetary policy:
– Reserve requirements
– Discount rate
– Federal funds rate
Reserve Requirements
The Federal Reserve is responsible for setting the reserve requirements for banks. Reserve requirements specify what percentage of a bank’s deposits the bank has to keep on reserve with the Fed. For instance, if the Fed sets the reserve requirement at 10 percent and a bank has $10 billion in deposits, the bank is required to keep $1 billion on reserve at the Fed.
The Fed is able to affect monetary policy by changing reserve requirements. When the Fed wants to decrease the amount of money in the system, it raises the reserve requirements for banks. This forces banks to pull money out of circulation and put it into reserve. When the Fed wants to increase the amount of money in the system, it lowers the reserve requirements for banks. This allows banks to pull money out of reserve and put it back into circulation.
Discount Rate
The Federal Reserve is responsible for setting the discount rate—the interest rate the Fed charges banks to borrow money at the Discount Window. The Discount Window is a facility where banks can borrow money directly from the Fed to meet reserve requirements or increase the amount of money they have available to lend to customers.
The Fed is able to affect monetary policy by changing the discount rate. When the Fed wants to decrease the amount of money in the system, it raises the discount rate. This discourages banks from borrowing money at the Discount Window because the cost of borrowing the money is so high. And when banks are not borrowing as much, they don’t have as much to put into the system by lending it out. When the Fed wants to increase the amount of money in the system, it lowers the discount rate. This encourages banks to borrow money at the Discount Window because the cost of borrowing the money is so low. And when banks are borrowing more, they have more money to put into the system by lending it out.
Federal Funds Rate
The Federal Reserve is responsible for setting a target for the federal funds rate—the interest rate banks charge each other to lend and borrow money on reserve at the Fed (also known as federal funds). You see, as banks deposits change, the amount of money they have to have on reserve at the Fed also changes. Sometimes banks have excess reserves, and sometimes banks have reserve shortages. To find a balance, banks with shortages borrow reserves from banks with excess on an overnight basis. The rate the borrowing bank pays to the lending bank is called the federal funds rate.
The Fed is able to affect monetary policy by changing its target for the federal funds rate. When the Fed wants to decrease the amount of money in the system, it raises its target for the federal funds rate. This discourages banks from borrowing federal funds from each other because the cost of borrowing the money is so high. And when banks are not borrowing federal funds from each other, they typically put more of their money on reserve to ensure they can meet their reserve requirements. This means they don’t have as much to put into the system by lending it out. When the Fed wants to increase the amount of money in the system, it lowers its target for the federal funds rate. This encourages banks to borrow federal funds from each other because the cost of borrowing the money is so low. And when banks are borrowing federal funds from each other, they typically put less of their money on reserve because they know they can meet their reserve requirements by borrowing from other banks. This means they have more money on hand to put into the system by lending it out.