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Federal Reserve Tools and How They Work

By

Ben Bernanke

Former Fed Chair Ben Bernanke was challenged to create many new tools to deal with the 2008 financial crisis.

Photo: Chip Somodevilla/Getty Images

The Fed funds rate is perhaps the most well-known Federal Reserve tool. However, it has many more at its disposal, and they all work together. Here's an introduction to them all, with links if you want to read more. the has several other tools which allow it to set monetary policy.

Reserve Requirement:

The reserve requirement refers to the amount of deposit that a bank must keep in reserve at a Federal Reserve branch bank. In December 30, 2010, it set at 10% of all bank liabilities over $58.8 million. The lower this requirement is, the more a bank can lend out. This stimulates economic growth by putting more money into circulation. A high requirement is especially hard on small banks, since they don't have as much to lend out in the first place. For that reason, there is no requirement for banks that have liabilities under $10.7 million. The requirement is only 3% for liabilities between $10.7 million and $58.8 million. In 2008, the Fed agreed to pay interest on the reserve requirement.

The Fed rarely changes the reserve requirement. For one thing, it is very expensive for the banks to change their policies and procedures to conform to a new requirement. More important, adjusting the Fed funds rate achieves the exact same result, with much less disruption and cost.

Fed Funds Rate:

If a bank doesn't have enough on hand to meet the reserve requirement, it will borrow from other banks. The Federal funds rate is the interest banks charge each other for these overnight loans. The amount lent and borrowed is known as the Fed funds. The Federal Open Market Committee (FOMC) targets a specific level for the Fed funds rate at its regularly scheduled meetings.

Open Market Operations:

Open market operations is how the Fed makes sure banks lend at its targeted Fed funds rate. The Fed uses open market operations when it buys or sells securities, such as Treasury notes or mortgage-backed securities, from the member banks. Buying or selling securities is the same as removing or adding them to the open market. The Fed will buy securities from banks when it wants them to drop the Fed funds rate to meet its target. They will, because they now have more money on hand and must lower rates to lend out all the extra capital. When the Fed wants rates to rise, it does the opposite -- it sells securities to banks, reducing their capital. Since there's less to lend, they can comfortably raise the Fed funds rate.

Discount Window:

The Fed uses the discount window to lend money to banks at the Fed's discount rate to meet the reserve requirement. The Fed's discount rate is higher than the fed funds rate. Banks usually only use the discount window when they can't get overnight loans from other banks. For that reason, the Fed usually only uses this tool in emergency, such as the during the Y2K scare, after 9/11 and the Great Recession. For more, see Financial Crisis Timeline.

Discount Rate:

The discount rate is the rate that the Federal Reserve charges banks to borrow at its discount window. It is usually a percentage point above the fed funds rate, because the Fed wants to discourage excessive borrowing.

Money Supply:

This is the total amount of currency held by the public, and is reported by the Fed weekly as:

  • M1, which is currency and check deposits
  • M2, which includes M1 plus money market funds, CDs and savings accounts.

The Fed increases the money supply by lowering the fed funds rate, which lowers the banks’ cost of maintaining reserve requirements. This gives them more money to loan, which gives consumers more money in their pockets.

Fed's Alphabet Soup:

The Fed created many new and innovative programs to combat the Great Recession. They were created quickly, so the names described exactly what they did in technical terms which may have made sense to bankers, but very few others. The acronyms resulted in an alphabet soup of programs, such as MMIF, TAF,CPPF,ABCP MMF Liquidity Facility. Although these tools worked well, they confused the general public, creating mistrust about the Fed's intentions and actions. Now that the financial crisis is over, these tools have been discontinued. Click on the hyperlink to learn more about several of them:

For more, see Fed's Toolbox. (Article updated June 24, 2013)
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