The Toolbox of the Federal Reserve

Mr. MizakEconomics

Review

• The Federal Reserve’s Purpose: Maintain financial stability through monetary policy

• How does the Fed control monetary policy?

– Through the use of multiple tools• There is no magic wand that creates desired outcome

Tool # 1- Change the Reserve Requirement

• The Fed has the ability to change the reserve requirements for member banks.– The lower the reserve requirement, the more

money that is available to loan.• The reverse is true as well

• Very small changes in the RR can have drastic effects

• Because of the drastic impact this tool is not often used

Tool # 2- Changing the Discount Rate

• When banks need money they have two options– 1) Borrow from the FED• The FED charges an interest rate known as the discount

rate

– Low discount rate= more money borrowed= more money in circulation

– Reverse is true as well

Tool # 3- Changing the Federal Funds Rate

• When banks don’t borrow from the Fed, they borrow from other banks– Charged an interest rate known as the Federal

Funds Rate– This rate is often lower than the discount rate– The Federal Funds Rate is the rate that is most

often changed– Low FFR = more money borrowed = more money

in circulation

Current DataThis Week Month Ago Year Ago

WSJ Prime Rate 3.25 3.25 3.25

Federal Discount Rate

0.75 0.50 0.50

Fed Funds Rate

0.25 0.25 0.25

11th District Cost of Funds

1.786 1.828 2.455

FFR- HistoricalYear FFR

2007 5.02

2002 1.67

1981 16.39

1961 1.95

Source: http://www.federalreserve.gov/releases/h15/data/Annual/H15_FF_O.txt

Tool # 4- Open- Market Operations

• The Fed can buy and sell government securities (Treasury bills, notes, and bonds)

• When the Fed purchases gov. securities, it deposits money into the selling bank.– This deposit increases the bank’s reserves

• Bank can lend more money

• When the Fed sells gov. securities, it withdrawals money from the purchasing bank– This withdrawals decreases the bank’s reserves

• Bank can lend less money

Problems of Monetary Policy

• No perfect solution• Despite availability of information, the Fed’s

actions do not always have desired effect• The Fed has made bad economic situations

worse• Has the Fed prevented more damage than it

has caused?