The Federal Reserve and Tools of Monetary Control

The Federal Reserve (the Fed) utilizes specific tools to control the money supply within the economy.
Changes to the money supply are the primary method through which the Fed influences interest rates.
Currently, the Fed has been active in cutting interest rates, which is achieved by manipulating the money supply (a process explored in depth in related chapters).
There are three primary tools of monetary control: * Open Market Operations. * Changing the Reserve Requirement. * Changing the Discount Rate.

Definition and Authority: Open market operations are conducted by the FOMC, which stands for the Federal Open Market Committee.
Mechanism: This tool involves the buying or selling of $U.S. \text{ government securities}$ , commonly referred to as bonds. * The Fed enters the bond market much like any other participant to conduct these transactions.
Impact on Money Supply: * Buying Bonds: When the Fed buys bonds, the money supply increases. By purchasing bonds from the public or banking sector, the Fed injects money into the economy. This money is typically deposited into the banking sector, where it undergoes the "multiply process" discussed in previous lessons. * Selling Bonds: When the Fed sells bonds, the money supply decreases. Money is taken out of the hands of the public/banks in exchange for the securities, removing it from circulation.
Usage and Frequency: * This is the most frequently used tool of the three. * The FOMC meets regularly every $6$ weeks to make decisions regarding these operations. * In specific circumstances, such as the current pandemic situation, the Fed may hold emergency meetings to enact these changes immediately. * Open market operations are preferred because they are less disruptive to the banking sector compared to the other tools.

Definition: The reserve requirement is the specific percentage of deposits that banks are legally mandated to hold in reserve. This money cannot be lent out to borrowers.
Mechanism and Relationship: There is an inverse relationship between the reserve requirement and the money supply. * Increasing the Reserve Requirement: This decreases the money supply. When banks must hold more money in reserve, they have less money available for lending. This results in less money being multiplied through the banking system. Furthermore, a higher reserve requirement leads to a lower money multiplier. * Decreasing the Reserve Requirement: This increases the money supply. Banks are required to hold less, allowing more money to be lent out and multiplied.
Disruptive Nature of the Tool: * The Fed rarely changes the reserve requirement because it can be highly disruptive, especially when the economy is functioning at a normal rate and banks are lending near their maximum capacity. * Hypothetical Scenario: If the reserve requirement is currently set at $10\%$ , and a bank holds $10.5\%$ in reserves to remain safely above the threshold, an abrupt increase by the Fed to $15\%$ would create a deficit for the bank. The bank would be forced to suddenly find ways to increase its reserves, such as calling in existing loans, which is highly disruptive to the financial system. * This tool is less disruptive only if banks are already holding significant excess reserves.

Definition: The discount rate is the interest rate that the Federal Reserve charges commercial banks for short-term loans.
Distinction from Federal Funds Rate: The discount rate is often confused with the federal funds rate. * The Federal Funds Rate is the interest rate banks charge one another for overnight loans. * The Discount Rate specifically involves the Fed loaning money directly to a bank.
Mechanism and Relationship: Similar to the reserve requirement, the discount rate has an inverse relationship with the money supply. * Increasing the Discount Rate: This decreases the money supply. A high discount rate makes borrowing from the Fed expensive. To avoid this cost, banks will "play it safe" by holding onto more excess reserves and lending out less, which reduces the overall money supply. * Decreasing the Discount Rate: This increases the money supply. If the rate is low, banks are more willing to lend out their reserves because they know they can borrow from the Fed cheaply if they fall short of their reserve requirements.

To Increase the Money Supply: * The Fed will buy bonds. * The Fed will lower the reserve requirement. * The Fed will lower the discount rate.
To Decrease the Money Supply: * The Fed will sell bonds. * The Fed will raise the reserve requirement. * The Fed will raise the discount rate.

Despite having these tools, the Fed does not have "perfect control" over the money supply due to two primary factors: 1. Household Behavior (Currency Outside Banks): The Fed’s control relies on the money multiplier process, which requires money to be deposited in the banking system. If individuals choose to keep their money in home safes or outside of banks (perhaps due to a lack of trust in the banking system), that money cannot be multiplied, thus limiting the Fed's influence. 2. Bank Behavior (Excess Reserves): The Fed can set limits on how much a bank cannot lend, but it has no power to force banks to lend money. * Historical Case Study: Following the financial crisis, and for approximately $4$ to $5$ years afterward, banks became extremely risk-averse. Even though they had the capacity to lend, they feared borrowers would default. Consequently, banks' excess reserves skyrocketed. * When banks hold vast amounts of excess reserves instead of lending them out, the multiply process is stifled, and the Fed's ability to increase the money supply is weakened.