Federal Reserve tools

The Federal Reserve has four tools it can use to enforce monetary policy. They are:

• The discount rate
• Open market operations
• Reserve requirements
• Margin requirements

The discount rate

The discount rate is the interest rate the Fed charges when a bank borrows directly from the Federal Reserve. Although the Fed tries to influence interest rates throughout the economy, the discount rate is the only rate it controls directly.

• If the Fed lowers the discount rate, banks can borrow more cheaply. That tends to increase lending, loosen the money supply, and push interest rates down for customers.
• If the Fed raises the discount rate, borrowing from the Fed becomes more expensive. That tends to reduce lending, tighten the money supply, and push interest rates up.

Open market operations

Open market operations are the Fed’s purchases and sales of securities with banks.

To loosen the money supply, the Fed buys securities from banks. These transactions are called repurchase agreements because the bank will buy back the securities at some point in the future. In the short term, the Fed is putting more cash into banks in exchange for securities the banks own (e.g., Treasury bonds). With more cash available to lend, interest rates tend to fall.

To tighten the money supply, the Fed sells securities to banks. This is the opposite of a repurchase agreement. These transactions are called reverse repurchase agreements. In the short term, the Fed is taking cash out of the system by exchanging securities for cash. With less cash available to lend, interest rates tend to rise. Later, the Fed will buy back the securities.

The Federal Open Market Committee (FOMC), a part of the Federal Reserve, oversees open market operations. It typically buys and sells certain types of securities, often Treasury securities and prime banker’s acceptances (short-term bank securities). In the past decade (especially during the COVID-19 crisis), the securities traded by the FOMC have expanded. For exam purposes, focus on what the FOMC typically trades, not the unique securities traded during an economic catastrophe. Of the four tools, open market operations are the tool the Fed uses most actively.

Reserve requirements

As discussed in the Rates chapter, banks must continually meet reserve requirements (the portion of deposits they must hold in reserve). The Fed can raise or lower these requirements to pursue monetary policy.

• If the Fed lowers reserve requirements, banks can lend out more of their deposits. That increases the amount of money in the financial system (loosening). With more money available to lend, interest rates tend to fall, and borrowing becomes cheaper.

Conversely:

• If the Fed raises reserve requirements, banks must hold more deposits in reserve and can lend out less. That decreases the amount of money in the financial system (tightening). With less money available to lend, interest rates tend to rise, and borrowing becomes more expensive.

Margin requirements

When investors use margin, they borrow money to invest. This is called leveraging, and it amplifies both gains and losses.

• If an investor borrows and the investment performs well, the investor can earn more than they would using only their own capital.
• If the investment performs poorly, the investor can lose more than they would using only their own money.

Regulation T was created to prevent investors from borrowing too much money. It requires investors to deposit 50% of the purchase price for initial margin transactions. For example, if you purchase $10,000 of stock in a margin account, Regulation T requires a deposit of at least $5,000.

• If the Federal Reserve wanted to loosen (expand) the money supply, it could lower Regulation T below 50%. That would allow investors to borrow more for investment purposes, expanding the money supply.
• If the Fed wanted to tighten (contract) the money supply, it could raise Regulation T requirements. That would reduce borrowing for investment purposes, decreasing the amount of money in the system.

To summarize, the Federal Reserve uses the following tools to implement monetary policy:

• Discount rate
• Open market operations
• Reserve requirements
• Margin requirements (Regulation T)

Many test takers remember these four tools by the acronym ‘DORM.’

Final summary

Let’s summarize the actions that correspond with loosening and tightening the money supply:

Loosening (growing) the money supply

• Lower the discount rate
• Pursue repurchase agreements
• Lower reserve requirements
• Lower margin requirements

Tightening (shrinking) the money supply

• Raise the discount rate
• Pursue reverse repurchase agreements
• Raise reserve requirements
• Raise margin requirements