Other Federal Reserve Tools and How They Work

In addition to the fed funds rate, the Federal Reserve has several other tools which allow it to set monetary policy. These tools are usually not used as frequently, nor do they gain as much press, as the Fed funds rate. However, they were used heavily by the Fed to shore up the financial markets during the Great Recession after the Fed funds rate was dropped to, essentially, zero.

The reserve requirement refers to the amount of deposit that a bank must keep in reserve at a Federal Reserve branch bank. As of December 30, 2010, it was 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.

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 Federal Intervention in the Banking Crisis.

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.

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.

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 which worked well, but confused the general public. For more, see Fed's Toolbox. (Article updated January 13, 2011)