Tools of the Federal Reserve

The Federal Reserve has four tools at its disposal when enforcing monetary policy. They are:

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

The discount rate

The discount rate is the Fed’s rate. If a large bank were to borrow directly from the Fed, it is assessed the discount rate. Although the Fed aims to influence general interest rates, the discount rate is the only rate it controls directly. When the Federal Reserve lowers the discount rate, banks can borrow money at cheaper prices, leading to lower interest rates for bank customers. The exact opposite occurs if the Fed raises the discount rate.

Open market operations

Open market operations involve the Fed buying and selling securities with banks.

To loosen the money supply, the Fed buys securities from banks. These types of transactions are known as repurchase agreements because the bank will buy back those securities at some point in the future. In the short term, the Fed is momentarily putting more money into the hands of banks in return for securities the banks own (e.g., Treasury bonds). When banks have more money on hand, interest rates tend to fall.

To tighten the money supply, the Fed sells securities to banks. Essentially, they’re doing the exact opposite of a repurchase agreement. Called reverse repurchase agreements, the Fed is momentarily taking money out of the system by selling securities to banks in return for cash. The banks have less money to lend out, leading to higher interest rates. 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. In the past decade (especially during the COVID-19 crisis), the securities traded by the FOMC have expanded. For exam purposes, it’s important to know what they typically trade, not the unique securities traded during an economic catastrophe. Of the four tools of the Fed, open market operations are the most actively utilized tool they use.

Reserve requirements

As discussed in the Rates chapter, banks must continually meet reserve requirements. The Fed can raise or lower those requirements to pursue its monetary policy. When the Fed lowers reserve requirements, banks can lend out more of their deposits, which increases the amount of money in the financial system (loosening). With more money to lend out, interest rates fall, and borrowing money is cheaper.

Conversely, when the Fed raises reserve requirements, banks lend out less of their deposits, which decreases the amount of money in the financial system (tightening). With less money to lend out, interest rates rise, and borrowing money is more expensive.

Margin requirements

We’ll learn more about margin in a future chapter, but you’ll only need to know the basics for now. When investors utilize margin, they borrow money to invest in the market. This is known as leveraging, which amplifies gains and losses. If the investor borrows money and makes a good investment, they’ll make more than if they only used their own capital. However, if the investor makes a bad investment with borrowed money, they’ll lose more than they would’ve if they only used their own money.

Regulation T was created to prevent investors from borrowing too much money. This rule requires investors to deposit 50% of initial margin transactions. For example, if you purchased $10,000 of stock in your 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%. By doing so, investors could borrow more money for investment purposes, expanding the money supply. If the Fed wanted to tighten (contract) the money supply, it could raise Regulation T requirements. By doing so, investors would borrow less for investment purposes, reducing the amount of money in the system.

To summarize, the Federal Reserve utilizes 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