The Fed Has Other Tools in Addition to the Fed Funds Rate:
In addition to the Fed Funds Rate, the Federal Reserve has several other tools which allow it to set monetary policy. These tools are not used as frequently, nor do they gain as much press, as the Fed Funds Rate. Their importance is because they allow the Fed to shore up the financial markets in case of emergency. This provides more stability to the U.S. financial system and economy.
Reserve Requirement:
The reserve requirement refers to the amount of deposits that a bank must keep on hand at all times, and never lend out. The higher this requirement is, the less profit a bank makes on its money. A high requirement is especially hard on small banks, since they don't have as much to lend out in the first place. Every time the Fed changes the requirement, banks have to make changes to their policies, which incurs a cost. For these reasons, the Fed hardly ever used this tool.
Discount Window:
The discount window is what the Fed use to loan money to banks at the Discount Rate to make sure they can meet the reserve requirement when they close each night. The Fed only changes this tool in emergency. For example, during the Y2K scare and again after 9/11, the Fed loosened their constraints on lending to make sure banks had plenty of money to loan, if needed.
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 public, and is reported by the Fed weekly as:
- M1 which is currency and check deposits
- M2, which includes M1 plus money market funds, CD’s and savings accounts. The Fed increases the money supply by lowering the Fed Funds Rate, which lowers the banks’ cost of maintaining reserve requirements, which gives them more money to loan, which gives consumers more money in their pocket.
