Tools of the Federal Reserve

The Federal Reserve has four tools it can use to carry out monetary policy:

• 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. While 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 a later date. In the short term, the Fed is putting cash into the banking system in exchange for securities the banks own (for example, Treasury bonds). With more cash available, banks can lend more, and interest rates tend to fall.

To tighten the money supply, the Fed sells securities to banks. These are called reverse repurchase agreements. In the short term, the Fed is taking cash out of the banking system in exchange for securities. With less cash available, banks have less to lend, and interest rates tend to rise. Later, the Fed will buy back the securities.

The Federal Open Market Committee (FOMC), part of the Federal Reserve, oversees open market operations. It typically trades 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, focus on what the FOMC typically trades, not the unusual securities used during an economic crisis.

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 Fed can raise or lower these requirements as part of monetary policy.

• When 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.

• When 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

We’ll cover margin in more detail in a future chapter. For now, you only need the core idea: when investors use margin, they borrow money to invest. This is called leveraging, and it magnifies 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 money.
• If the investment performs poorly, the investor can lose more than they would using only their own money.

Regulation T was created to limit how much investors can borrow. It requires investors to deposit 50% of the purchase price for initial margin transactions.

For example, if you buy $10,000 of stock in a margin account, Regulation T requires a deposit of at least $5,000.

• If the Fed 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. That would reduce borrowing for investment purposes, shrinking the money supply.

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

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

Many test takers remember these four tools with the acronym “DORM.”

Final summary

Here are the actions that correspond to 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