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Fiscal Policy and The Federal Reserve’s Toolbox

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The United States has a fascinating banking history. The first attempt at a centralized bank was in 1791, and it wasn’t until 1913 that the Federal Reserve System we use today was born. The Federal Reserve System is responsible for many financial activities, most of which go unnoticed by the general public on a day-to-day basis. However, following the near-collapse of our financial system in 2008, the Federal Reserve became a more visible force and awareness of the power and influence of our central banking system grew.

The Federal Reserve is tasked with determining and controlling the United States’ monetary policy. Monetary policy is the term used to describe the actions taken by the Fed to increase or decrease the size of the nation’s money supply. By adjusting money supply, the Fed attempts to maintain a steadier trajectory in the economy. The toolbox of the Federal Reserve contains a variety of financial tools that it can use to meet its goals. In this post, we’ll focus on three of the more well-known tools: reserve requirements, discount rate and federal funds rate, and open-market operations.

  • The reserve requirement is the portion of deposits that banks must refrain from loaning to borrowers and keep in reserves at the bank. For example, if the reserve requirement is set at 5%, the bank must retain $5,000 of every $100,000 in deposits. A higher reserve requirement results in a tighter monetary supply, as it restrains banks’ ability to make loans. Tighter monetary supply acts as a brake on the speed of the economy.
  • The discount rate is the interest rate charged by the 12 Federal Reserve Banks to the member banks who borrow funds from the Fed. Banks are forced to borrow money when their retained deposits do not meet the reserve requirement. The Fed controls the amount banks borrow by increasing or decreasing the cost to borrow funds. Banks may also borrow money from other banks, rather than from the 12 Reserve Banks, at a rate known as the federal funds rate. The federal funds rate is typically lower and is a more attractive option for bank borrowing.
  • Open-market-operations (OMO) are arguably the most popular and most powerful tools available to the Fed. The Federal Reserve controls the supply of money by buying and selling U.S. Treasury securities. If the Fed wishes to stimulate the economy and promote growth, it purchases securities from a bank or dealer. By paying for the securities, the Fed provides assets to the bank that it can then loan to businesses and consumers. Usually, the result is increased spending and lower interest rates. To tighten the monetary supply and slow the economy, the Fed sells securities. When banks purchase the securities, the Fed collects the funds from the purchase and removes the money from the economy, which reduces the amount of money banks can loan and aids in the goal of increasing interest rates.

The Federal Open Market Committee (FOMC) is the body responsible for monetary policymaking. They have eight scheduled meetings annually, but may meet more frequently as needed. In recent years, the Fed has made an effort to provide more information to the public to help explain its activities. Test your knowledge by tuning in and interpreting the policy-making decisions made by the Fed in their next meeting.

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