The Toolbox of the Federal
Reserve
Mr. Mizak
Economics
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 Data
This Week
Month Ago
Year Ago
WSJ Prime Rate
3.25
3.25
3.25
Federal Discount
Rate
0.75
0.50
0.50
0.25
0.25
0.25
1.786
1.828
2.455
Fed Funds Rate
11th District Cost of
Funds
FFR- Historical
Year
FFR
2007
5.02
2002
1.67
1981
16.39
1961
1.95
Source:
http://www.federalreserve.gov/rel
eases/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?