The Federal Reserve was created in 1913 by the Congress of the United States. The Fed Reserve was created after the realization that money should be controlled by the government and that it should be a public matter rather than a private one. The sole purpose for this central bank is to provide some type of control over the money supply. The Federal Reserve acts like a central bank in the United States. It creates and controls the country’s monetary policy, it provides the supervision and regulation of banks, it grants financial support for many institutions but most importantly, it has the task of making sure the economy is stable.
The government issued the Federal Reserve Act of 1913 in order to give the Federal Reserve the task of creating policies to monitor and control the money supply. The Federal Reserve has since then created three major policies to control money: 1) Open Market Operations and the Federal Funds Rate 2) The Discount Rate 3) Reserve Requirements
e. i. Open Market Operations and the Federal Funds Rate
The Open Market Operations (OMO) is currently used on a day-to-day basis and sometimes even hourly. The policy has a direct effect on the money supply and an indirect effect on the interest rates. In an open market operation, the government sells or buys bonds in order to change the money supply in the economy.
The Federal Open Market Committee closely examines the money supply and determines if it needs to be expanded or contracted. If the money supply needs to increase, the Fed buys more bonds. The Federal Reserve purchases the government bonds in the open market with currency. As a result, commercial banks now have more currency and thus more money in their reserves. The bank now has an excess of reserve that they are able to use in order to increase their loans. The excess reserve also increases the bank’s deposit. The interest rate in this situation drops as the Fed buys more bonds and as the bond prices increase.
Expansionary: Fed buys bonds Money Supply MS Price of bonds interest i
An example of a situation in which the money supply needs to increase is when there are long holiday weekends coming up. Before holidays like labor day weekend or memorial day weekend, people go to their banks and withdraw a lot of money from their accounts (for the upcoming vacation, etc) and as a result, the bank’s reserve will drop. The Federal Reserve anticipates these withdraws and buys bonds in order to increase the banks reserves and the money supply.
The Fed Reserve may also sell bonds in situations where they need to decrease the money supply.
Contractionary: Fed sells bonds Money Supply MS Price of bonds interest i
The federal funds rate is the interest rate paid when a bank borrows from another member bank that has an excess of reserves. The rate is not fixed and is determined by the market. However, the Federal Reserve monitors the federal funds rate and makes sure it doesn’t get too high or low. The Fed makes sure that federal funds rate does not differ too much from their target federal funds rates.
e. ii) The Discount window and discount rate
The discount rate is the interest rate that the Federal Reserve charges for member banks to borrow reserves. Member banks borrow reserves from the Fed when their own reserve is low and barely (or doesn’t) meet the reserve requirement. The discount rate is a set rate and changed only by the Fed. This policy instrument is used every couple of months or whenever necessary. The discount rate directly affects the interest rate and indirectly affects the money supply. When the discount rates are low, banks are more willing to borrow at that cheaper rate from the Fed. The discount rate is important because it sets the basis for all interest rates and sets the lowest rate in the market.
The discount window is the Federal Reserve’s facility that lends out the money to member banks. There are three discount window programs with their own interest rate: primary credit, secondary credit and seasonal credit.
The primary credit program is available for a short-term period, usually just overnight. The banks that generally use this program are well-established and financially secure. They often use this program as their “back up” funding because the interest rate is set above the federal funds rate and thus it is more expensive to borrow through the primary credit.
If a bank is not eligible to receive the primary credit program, they often apply for the secondary program. This program offers a rate above the primary credit rate.
The seasonal credit program is for small banks that experience fluctuations in their loans and deposits. These banks have high volumes or low volumes of activity during certain seasons. Only banks that have a clear recurring pattern of fluctuations may obtain the program. These banks are usually in tourist areas (i.e. a seasonal resort) or agricultural communities. The interest rate for the seasonal program varies depending on the market rate.
e. iii. Reserve Requirements
A reserve requirement is the minimum reserve-deposit ratio that banks must have in its reserves. Banks are required to set aside a certain amount of deposits in their reserves and can not use this reserve for loans or investment. The reserve is set aside as the “back up” for deposits. This is the oldest policy instrument of the Fed and rarely changes. It is mostly used in developing countries.
If the Federal Reserve increases the reserve requirement than banks will have to keep more of their money in reserves and will have less money available for loans or investment. If the reserve requirement is lowered, banks will have more money to lend out and invest.