The Federal Reserve has many roles, but the single most important responsibility is to
control the nation’s money supply. Remember that monetary policy is changes to the money
supply in order to achieve particular macroeconomic goals; and in the US, the Fed controls monetary
policy and the money supply. Making more money available, expansionary policy, makes it easier
to spend, so aggregate demand increases. Making less money available, contractionary policy,
makes it more difficult to spend so aggregate demand falls. The question now is: How does
the Fed control, or make changes to, the money supply?
The Fed has three major tools to control the money supply: 1) Open Market Operations, or
OMOs, 2) the required reserve ratio, and 3) the discount rate. How does each of these
work, and which tool or tools does the Fed prefer? Let's take them one at a time.
Open Market Operations. Just as with fiscal policy, monetary policy can be either expansionary,
stimulating the economy, or contractionary, slowing the economy. If open market operations
are the buying and selling of government securities, which is expansionary, and which is contractionary?
Let's look at an example of an open-market purchase where the Fed buys $1 million of
securities, or government bonds, from Wells Fargo. The Fed sees a change in its asset
mix as it increases its holdings of securities, and decreases its holdings of cash, depositing
$1 million into Wells Fargo's account. Wells Fargo also sees a change in its asset mix,
with $1 million less in government securities, but $1 million more on deposit with the Fed.
The big difference is that $1 million in securities can’t be loaned out, but $1 million in bank
reserves, or at least some fraction of it, can be lent out. With the open-market purchase,
the Fed has injected $1 million into the economy, plus whatever additional effect from the lending
of the excess reserves, making this expansionary policy.
What about an open-market sale? Let's say that the Fed sells $1 million of government
securities to Bank One. The Fed sees a decrease its holdings of securities, but Bank One pays
the Fed $1 million – actually, the Fed just deducts the amount from Bank One's Federal
Reserve deposits. Bank One now has $1 million less on deposit at the Fed -- that’s $1
million less in actual bank reserves -- but has $1 million more in securities. What this
means is that Bank One now has less money to lend, and less money in circulation means
less spending, slowing down the economy. Therefore, an open-market sale is contractionary monetary
policy.
What about the second tool, the required reserve ratio? We’ve seen this one action already,
when we examined how the banking system creates money, but let me recap. Recall that the maximum
change in checkable deposits, and therefore the money supply, is [1/r x the initial change
in reserves]. For example, if the change in reserves is $500, and the required reserve
ratio -- that is, the percentage of total deposits that the bank is legally required
to hold onto -- is 10%, then the maximum change in the money supply is [(1/.1)x$500], or 10
(the money multiplier) x $500, or $5000.
Now, what if the Fed increases the required reserve ratio to 20% (technically, according
to the Monetary Control Act of 1980, the Fed is only allowed a range from 8% to 14%, but
let’s just use 20% hypothetically; it makes the math easier). What's going to be the new
maximum possible change in the money supply? With a required reserve ratio of .2 (that's
20%), the multiplier is now (1/.2), or 5, so the maximum change is [5x$500], or $2500.
This means that raising the reserve requirement is contractionary monetary policy, since the
overall possible change is half what it was before, slowing the economy. This makes sense,
since a higher reserve ratio means that banks are legally required to hold onto more reserves,
leaving less to lend out.
What if the Fed decreases the reserve requirement to 5%? Now the multiplier, [1/r], or [1/.05],
is 20. So a $500 change in reserves can make up to a $10,000 difference in the money supply.
Decreasing the required reserve ratio makes more money available for lending, thereby
increasing spending in the economy -- an expansionary monetary policy
The third tool, the discount rate, is the interest rate at which commercial banks can
borrow from the Fed. This one is pretty common sense; at a higher interest rate, banks are
less inclined to borrow, which slows the economy, or contractionary policy; at a lower interest
rate, banks are more inclined to borrow, putting more money in circulation, and stimulating
the economy -- expansionary policy.
Here's the kicker, though: sometimes even at very attractive rates, banks don't want
to borrow from the Fed. To borrow money, a bank can go to other commercial banks, or
they can go to the Fed. Borrowing from other banks means entering the Federal Funds Market,
and being subject to the federal funds rate, the interest rate that banks charge each other.
Borrowing from the Fed means paying the discount rate, or the rate at which the Fed lends to
member banks. Which will the borrowing bank choose? You’d think it would be the lower
interest rate, wouldn’t you? Well, oddly enough, even if the discount rate is less
than the federal funds rate, a bank still may go the Federal Funds market for the loan.
Why?
Well, for a few reasons really. First, there's the purpose of the loan. That is, the Fed
frowns on making loans for risky profit ventures. Second, consider the Fed bureaucracy. Among
the functions of the Fed, one is to supervise member banks. Do you want to ask your supervisory
entity for a loan, or multiple loans? Borrowing too often from the Fed might look like bad
management, opening your bank up to an audit. Third, there's the fact that borrowing from
the Fed is a privilege, not a right, for member banks. If you abuse the privilege, you may
be turned down in the future. For all of these reasons, the Fed is referred to as the lender
of last resort.
So which tool – OMOs, the required reserve ratio, or the discount rate -- does the Fed
prefer to use? The Fed tends to use open-market operations the most, for several reasons.
1) OMOs are flexible. The Fed can conduct sales or purchases in any dollar amount that
they want. 2) OMOs are reversible. If the Fed conducts an open-market purchase today,
it can turn right around and conduct an open-market sale tomorrow. 3) Quick implementation. Fed
OMOs take place very rapidly, as transactions occur electronically. You've seen the discount
rate drawback -- many banks prefer not to borrow from the Fed unless absolutely necessary;
and changing the required reserve ratio is like trying to use a sledgehammer on the economy.
In the end, the Fed prefers to try fine-tuning the economy with OMOs.
NEXT TIME: Exchange rates TRANSCRIPT00(MACRO) EPISODE 32: MONETARY POLICY