SS.912.E.1.11 Explain how the Federal Reserve uses the tools of monetary policy (discount rate, reserve requirement, open market operations) to promote price stability, full employment, and economic growth Standard 1 Understand the fundamental concepts relevant to the development of a market economy SS.912.E.1.11 Explain how the Federal Reserve uses the tools of monetary policy (discount rate, reserve requirement, open market operations) to promote price stability, full employment, and economic growth

Three tools of the Fed to control the money supply: 1)Reserve requirements The US banking system operates as a fractional reserve system- banks must keep a portion (currently 10% for most banks) of their total deposit value amount as either vault cash or required reserves at a Fed branch Required reserves cannot be loaned out; they are held to “protect” banks from runs by depositors Each bank conducts an accounting at the end of each business day to calculate required reserves

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Three tools of the Fed to control the money supply: 1)Reserve requirements If the Fed decreases reserve requirements (i.e. lowers from 10%), then it engages in expansionary monetary policy because more reserves are able to be loaned out If the Fed increases reserve requirements (i.e. raises from 10%), then it engages in restrictive monetary policy because fewer reserves are able to be loaned out

Three tools of the Fed to control the money supply: 2)Open Market Operations The FOMC in NY buys and sells bonds (i.e. securities) If the Fed buys directly from a member bank, it “pays” the bank with excess reserves If the Fed buys from someone else, the effect is the same because the cash payment will usually end up as a new deposit at a bank If the Fed buys bonds, then it engages in expansionary monetary policy because more excess reserves are able to be loaned out If the Fed sells bonds, then it engages in restrictive monetary policy because fewer excess reserves are able to be loaned out

Three tools of the Fed to control the money supply: 3)Discount rate When banks borrow and lend to each other to meet required reserves, they do so in the federal funds market and use the federal funds interest rate to make transactions Even though the Fed is not directly involved in these transactions, it can influence the fed funds rate by making excess reserves more scarce or more plentiful See S&D analysis in the market

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Three tools of the Fed to control the money supply: 3)Discount rate The Fed prefers member banks to borrow from the fed funds market. If a bank cannot borrow the necessary funds to meet required reserves, it can turn to the Fed Hence the term “lender of last resort” If a bank borrows from the Fed, the bank pays the discount rate which is typically 0.5 to 1% higher than the fed funds rate Even today, there is a large negative stigma for a bank to borrow from the discount window

Three tools of the Fed to control the money supply: 3)Discount rate If the Fed lowers the discount rate, then it engages in expansionary monetary policy because more excess reserves will be loaned to member banks If the Fed raises the discount rate, then it engages in restrictive monetary policy because fewer excess reserves will be loaned to member banks

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

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

What do you think happened to excess reserves? Excess Reserves of Depository Institutions, 1980 to the present

Recent Changes in Monetary Policy 1)Changes in Open Market Operations a)Previously only bought and sold U.S. Treasury Bonds b)Now buy and sell broad range of assets  Mortgage-backed securities, commercial paper, corporate bonds  Has same effect on money supply 2)Extension of Loans a)Fed previously gave loans only to member banks for a short periods of time b)Fed now gives loans to non-bank financial institutions for long time periods rev Fed Operations and Monetary Policy

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 Facility PDCF is Primary Dealer Credit Facility AIG is American Insurance Group financial rescue ML is Maiden Lane (Bear Stearns financial rescue) Agency is short-term debt issued by Fannie Mae and Freddie Mac TAF is Term Auction Facility Repos are collaterilized loans