The Federal Reserve System's major tools to control the money supply and broad financial conditions are (a) reserve requirements, (b) open-market operations, and (c) discounting operations. Secondary tools of the FED include controls over stock market credit and moral suasion ("jawboning""). Day in and day out, the FED actively uses open-market operations to implement its ever-changing policies. Reserve requirements and discounting operations are important, though generally less frequently used instruments of monetary policy.

Reserve Requirements

 

A bank's reserves can be kept in its vaults or on deposit at Federal Reserve banks.

The Federal Reserve System sets the reserve-requirement ratio (rr)---a legal floor on the percentage of a bank's deposits that must be held in reserves.

            Banks cannot survive for long if reserves sink to the legal minimum; they need excess reserves to accommodate any outflows of funds. Otherwise, they could not meet any demands for withdrawals of demand deposits (DDs) without being in trouble with the FED.

 

            bank reserves  = required reserves (rr ¢ DD)  + excess reserves (XR)

 

            Note that all reserves available to meet the FED's reserve requirements are bank reserves, which include both excess reserves and required reserves. The overall banking system usually operates with very few excess reserves, however, because banks lend and borrow money from each other daily through the privately-operated federal-funds market.

 

Electronic Banking and "Real Money"

 

            On average, people today handle much less cash relative to their income than was typical in earlier times. Electronic deposits of paychecks and payments of bills are increasingly common, automatic teller machines (ATMs) are sprouting like weeds as ready sources of cash, and credit cards have replaced cash for many purchases. Therefore, a rising proportion of our money is stored in banks. But do banks keep much "real money" in their vaults? If real money is interpreted as meaning bills and coins, the answer is "Not much." Banks keep enough currency on hand to meet their depositors' demands for cash withdrawals, and that is about it.

 

            A typical bank now holds deposits of well over $50 million. Where do they store all these funds? You learned in the previous chapter that banks in a fractional reserve system hold only a portion of their deposits as reserves. However, no bank would ever hold tens of millions of dollars in cash---there is no sense in tempting thieves. Consequently, banks deposit most of their reserves with Federal Reserve Branch or District Banks.

 

            Even these FED banks do not hold many deposits in the form of cash---keeping track of inventories of tons and tons of the green stuff would be a monumental problem. You know that your bank account is simply a few electronic impulses stored in the bank's computer. The FED does the same thing with reserves banks keep on deposit at Branch or District Banks---it is all in the computer. Roughly two-thirds of the nation's money supply now exists only in computers.

 

Reserve Requirements and the Money Multiplier

 

            One way the FED adjusts the money supply is by changing the reserve-requirement ratio (rr). If the FED increases the reserve-requirement ratio, then the potential money multiplier, 1/rr, falls. The smaller potential money multiplier (mp) means the total reserves in the banking system will support only smaller potential totals of loan-based demand deposits. Conversely, a decrease in the reserve-requirement ratio enables banks to increase the money supply through expansion of demand-deposit-based loans.

 

            Most banks try to hold roughly the same percentage of excess reserves against demand deposits no matter what happens to the reserve-requirement ratio. Why? Because fluctuations of bank deposits depend on people's behavior---not on the FED's reserve requirements. Notice that the reserve-requirement ratio does not influence the total amount of reserves in the banking system. Instead, it affects the potential multiplier mp. Naturally, whenever the mp changes, the actual money multiplier (ma) moves in the same direction.

 

            The amounts of excess reserves held by banks are negatively related to the expected profitability of lending any excess reserves, but positively related to the expected costs of acquiring reserves should borrowing be necessary to meet the FED's reserve requirements. In other words, the percentage of deposits held as excess reserves will be negatively related to the difference between (a) the interest rates banks can charge borrowers and (b) the interest rates banks themselves must pay to borrow reserves from other banks or the FED.

 

            The reserve-requirement ratio (rr) is the FED's most powerful tool. Suppose that the rr were increased from 1/6 (16.7 percent) to 1/5 (20 percent)---a change of 3.3 points. The potential money supply would fall by 1/6 (mp falls from 6 to 5). Curiously, this powerful tool is seldom used. Reserve-requirement ratios have been changed only about 30 times since the Great Depression because the very power of such changes makes it difficult to predict the magnitude of their effect. A second tool of the FED, open-market operations, is the best tool available for the day-to-day conduct of monetary policy. It permits more subtle changes in the money supply.

 

 

Open-Market Operations (OMO)

 

The FED's most important tool, open-market operations, links monetary policy with the bonds issued by the U.S. Treasury to finance federal budget deficits.

Open-market operations (OMO) entail buying and selling U.S. Treasury securities and are used to increase or decrease the size of the monetary base.

           

            The monetary base (MB) is defined as total currency held by the nonbanking public plus reserves held by banks: MB = currency + bank reserves. Thus, the monetary base is the foundation for our money supply because the money creation process builds from reserves in the banking system.

 

            The FED's Open Market Committee (FOMC) adjusts the size of the monetary base through open-market purchases or sales of U.S. Treasury securities. To increase the money supply by expanding the monetary base, the FOMC's "open-market desk" buys Treasury bonds---primarily from banks, but also from private individuals or nonbank firms. The FOMC sells bonds to reduce the monetary base. Funds the FED pays to nonbank sellers are invariably deposited in banks, however, so they end up as bank reserves. Similarly, private buyers of bonds withdraw funds from banks to pay for their purchases. Thus, regardless of with whom the FED deals, the effects on total bank reserves and the money supply are similar.

 

            When the FED buys bonds, bank reserves are increased and the banking system will increase loan-based demand deposits in accord with the money creation process discussed previously. You may wonder where the FED gets the money to buy the bonds. The answer is that the FED can print new currency or it can simply credit the reserve accounts of the private banks via computer at one of the Federal Reserve District Banks.

 

            "T-account" entries for an expansionary open-market transaction are shown in Table 1. When the FED buys $1,000 in Treasury bonds from Bank A, the Federal Reserve Bank credits reserves held for Bank A by $1,000 and the FED's assets rise by $1,000 in Treasury bonds. Bank A's assets change from $1,000 in Treasury bonds to $1,000 in new reserves. Bank A views the sale of the bond to the FED just as it would a payback of a loan by a private borrower. Note, however, that this "payoff" creates new reserves for the banking system as a whole, while repayment of a private loan does not. These new reserves can then be loaned to private borrowers, creating new demand deposit money via the expansionary money multiplier process.

 

Table 1  T-Account Changes for a Typical Open-Market Transaction
Federal Reserve Bank
Assets	Liabilities
+$1,000 Treasury bonds	+$1,000 Reserves held for Bank A
Member Bank A
Assets	Liabilities
-$1,000 Treasury bonds +$1,000 Loanable reserves	No change

            You learned that a decline in the monetary base underpinning the money supply precipitates a "money destruction" process. If the FED wants to shrink the money supply, it can sell bonds to commercial banks. This reduction of the monetary base sops up excess reserves and may even threaten to cut into banks' required reserves. The amount of loan-based demand deposits falls as banks try to rebuild their reserves, turning down applications for new loans or renewals of old ones. The "money destruction" process following a FED sale of Treasury bonds precisely reverses the money creation process. If the positive numbers in Table 1 were negative, and vice versa, the table would illustrate a contractionary open-market operation.

 

            You may wonder how the FED can persuade banks or individuals to sell bonds when the FOMC conducts expansionary open-market operations. A bidding process is used; the sellers are those willing to offer desired amounts of bonds at the lowest prices. No matter how high the prices are, the FED buys the bonds, as Focus 1 illustrates. When the FED wants to withdraw reserves from the banking system to reduce the money supply, it sells some Treasury bonds from its portfolio. The FED takes the highest bids for bonds it sells, no matter how low the bids are.

            Actually, the open-market desk of the FOMC both buys and sells bonds every business day, primarily to adjust the maturity dates of the bonds it holds, but also, occasionally, to mask the direction of its policies.

 

1.         If the FED buys more bonds than it sells, total bank reserves are increased and the money creation process leads monetary growth.

2.         If the FED sells more bonds than it buys, reserves are reduced and the money destruction process causes the money supply to shrink.

 

            Open-market operations ultimately affect the money supply only through changes in the amounts of reserves in the banking system, not through changes in the money multiplier. The maximum possible value of the multiplier (mp) is determined by the reserve-requirement ratio (rr). The FED's discounting operations, however, affect both the size of the monetary base (MB) and the value of the actual money multiplier (ma).

 

Discounting Operations

 

            The FED is a bankers' bank. When banks lack sufficient reserves to meet reserve requirements or want more excess reserves, they can borrow funds from the discount windows of the FED's District or Branch Banks. Loans from the FED become a part of a bank's reserves, increasing the monetary base and, consequently, the money supply.

The interest rate the FED charges bankers is called the discount rate (d).

 

            Most bank borrowing from the FED is to cover temporary deficiencies. Whether banks will have deficient reserves, however, depends strongly on the discount rate. Whenever the discount rate (d) is substantially less than market interest rates (i), the monetary base grows---the FED extends credit (reserves) to banks, which allows bankers to expand their loans and demand deposits. When the discount rate the bank pays is below the interest rate it charges on loans, it is a bit like trading nickels for dimes.

 

            On the other hand, a discount rate that greatly exceeds market rates of interest penalizes bankers forced to borrow from the FED because of unforeseen withdrawals. Banks consequently try to avoid any need to borrow by holding greater excess reserves (although they often avoid borrowing from a District Bank by borrowing through the federal funds market). Thus the actual multiplier ma shrinks as the differences between the discount rate and the market interest rate grows.

            All else equal,

1.         When the  discount rate is raised, banks borrow less, reducing total reserves or limiting their increase. Banks also lend less, so excess reserves in individual banks grow while the actual money multiplier and money supply decline.

2.         When the FED decreases the discount rate, banks borrow  more from the FED and cut holdings of excess reserves; this increases the actual money multiplier and money supply.

 

The FED's Secondary Tools

 

Although the reserve-requirement ratio, open-market operations, and the discount rate are the major tools at the FED's disposal, other devices in the FED's toolbox help it control financial markets and economic activity:

1.         The FED sets margin requirements to control stock-market credit.

2.         The FED uses moral suasion (it "jawbones") which means it rages at people or institutions who do things it does not like.

Until the 1980s, the FED could also (a) regulate credit to consumers and business firms during wars or crises, and (b) set the maximum interest rates payable to depositors. Congress rescinded both these FED powers during a wave of deregulation.

 

Margin Requirements

 

            Many people blamed overspeculation caused by buying on margin for the Stock Market Crash of 1929 and the Great Depression. In the 1920s, stock could be purchased with down payments of as little as 10 percent.

The FED sets the margin requirement (the percentage down payment required) for purchases of corporate financial securities.

            Many 1920s' investors used almost all their assets for the 10% margin payments on stock. When the stock market crashed these investors were required to make up the losses. Since they only had 10 percent of the original value of the stock invested, these additional payments were impossible for many. When they could not produce the additional funds, they were wiped out. In the aftermath of 1929, the Federal Reserve System was granted power to regulate margin requirements, which have hovered around 50 percent for decades. Presumably, higher margin requirements squelch speculation and lower margin requirements stimulate speculation.

 

            Evidence is sparse, however, that margin requirements influence stock prices very much. Indeed, a powerful theory suggests that prudent financial investors will offset any speculative bubble caused by stock buyers overly enthused by low margin requirements. Suppose financial investors expected a 10 percent return on stocks but a 12 percent return on equally risky real estate. Funds would flow into real estate from the stock market. The stock market would fall a bit, and real estate prices would rise until the returns were equalized at, say, 11 percent.

 

            These sorts of adjustments will cure even minor overspeculation in stocks. If low margin requirements prompt speculation that boosts stock prices slightly, the expected returns (dividends, etc.) per dollar invested in stocks decline. This makes real estate or other investments comparatively more attractive to prudent investors, so money will flow from the stock market until the returns from all investments are equated. Overspeculation in stocks because of low margin requirements is thus, eliminated automatically.

 

Moral Suasion

 

            Self-restraints on increases in prices or union wages are commonly advocated by presidents trying to contain inflation. In 1992, President Bush hammered credit card companies for "high" interest rates that inhibited growth out of the recession that ultimately may have cost him reelection. Little evidence exists, however, that his vocal displeasure did much to lower credit card interest rates.

Moral suasionis oratory or the threat of tighter regulation used when policymakers want people or institutions to act against their individual interests (or to see their interests in a different light).

            The FED occasionally has tried to "jawbone" banks into expanding or contracting credit, but economists tend to be somewhat skeptical that appeals to the public interest are effective. On the other hand, president Clinton's appeal to drug companies to reduce rates of price increases for prescription drugs has had some apparent effect. Local gas companies often ask people to reduce thermostats during cold snaps to preserve supplies, and people often comply.

 

            The FED's moral suasion may have some effect, however, because it is backed up by the power to audit and otherwise harass banks. A major problem is that moral suasion is less predictable than virtually any other tool. Although once common, in recent years the Federal Reserve System has seldom exhorted bankers to do much that is contrary to their own interests.

Which Tools Are Used?

 

The Federal Reserve System strongly influences the money supply, but it lacks precise and direct control. The FED could not, for example, track bills that might have dissolved if you ever forgot to empty your pockets before putting clothes through a washing machine. Nor can it precisely dictate the loans banks make. We indicated earlier that the money supply (MS) is the product of the money multiplier (ma) and the monetary base (MB):

            MS = ma  x  MB.

 

            The FED can actively change the discount rate or reserve-requirement ratios to try to manipulate the value of the actual money multiplier and thereby change the money supply. Alternatively, it can use open-market operations (and, to a lesser extent, discount operations) to vary the monetary base in attempts to alter the money supply. Table 2 summarizes how tools of the FED affect the money supply by altering the behavior of banks and the public.

Table 2  Fed Tools and Effects
Tool Used	Potential Money Multiplier (mp = 1/rr)	Excess Reserves Ratio (xr = XR/DD)	Actual Money Multiplier (ma = MS/MB)	Monetary Base (MB)	Currency in the hands of the non-banking public	Bank Reserves	Loans, Demand Deposits, and Money Supply (M1)
Reserve requirement ratios (rr)
Raise rr	Lower	No change	Lower	No change	No change	No change	Lower
Lower rr	Higher	No change	Higher	No change	No change	No change	Higher
Open- market operations
Buys bonds	No change	No change	No change	Higher	Higher	Higher	Higher
Sells bonds	No change	No change	No change	Lower	Lower	Lower	Lower
Discounting operations
Lower rate	No change	Lower	Higher	Higher	Higher	Higher	Higher
Raise rate	No change	Higher	Lower	Lower	Lower	Lower	Lower
Moral suasion	No change	Ambiguous	Ambiguous	No change	No change	No Change	Ambiguous
Stock market margin requirements	Lower margin requirements presumably cause more stock market speculation while higher margins presumably discourage speculation. There is, however, little statistical support for this proposition and a powerful theory that refutes it.
*Note: Unless interest rates paid on deposits change, households and firms are assumed to keep stable proportions of their money holdings in the forms of cash and demand deposits, respectively.

            If the FED does not independently determine the money supply, what other groups have influence, and how? The FED does tightly control the monetary base through open-market operations. The public can affect the money multiplier through its holding of cash. As private stores of cash grow, currency available for bank reserves shrinks; the actual money multiplier and the money supply fall because the money expansion process only applies to currency in bank vaults or reserves at the FED. Banks also may unintentionally alter the actual money multiplier by varying their percentages of excess reserves: The greater the excess reserves held by banks, the smaller will be the actual money multiplier and the money supply.

            If private activities can alter the actual money multiplier and thwart the desire of the FED to change the money supply, then which tools most effectively accomplish the FED's goals? Any versatile do-it-yourselfer accumulates some tools that rust because they are seldom, if ever, used. This analogy applies to moral suasion and to changes in stock-market margin requirements, which are used only rarely. Reserve-requirement ratios are seldom varied, and then only slightly. They are too powerful to be very useful.

 

            The discount rate has been pegged slightly above interest rates in the federal-funds market for almost 30 years. This prompts banks to borrow from each other through the privately-operated federal funds market and discourages borrowing from the FED. The discount rate is seldom changed more than three times a year to reflect changes in interest rates in the federal-funds market. Changes in the discount rate normally are not intended to affect the money supply directly, because the FED wants the actual money multiplier to be constant. Thus, discount rate changes are intended to stabilize the percentage of deposits held as excess reserves.

 

            Open-market operations are the best tool to control the money supply by directly altering the reserves in the banking system. In the long run, open-market operations do not affect the money multiplier. Active changes in reserve-requirement ratios or the discount rate operate primarily through changes in the actual money multiplier, but these sorts of manipulations have yielded erratic and unsatisfactory results when used. Open-market operations are now the FED's most-used tool.