What is “The Fed”? (Part 2)

The Fed uses three tools:

  • The reserve requirement
  • The discount rate
  • Open market operations
  • The reserve requirement is the balance that banks must maintain, which is typically a percentage of their total Interest-bearing and non-Interest-bearing checking account deposits (currently 3% to 10%), to ensure that the bank will always be able to give you your money when you ask for it. Changing this requirement has a very large affect on the economy and Is rarely used. The last time the rate was changed was in the early 1980’s.

    In the event that a bank’s money supply drops below the required reserve amount, that bank can borrow either from another bank or from a Reserve Bank. If it borrows from another bank’s excess reserves, then the loan takes place in a private financial market called the federal funds market. The federal funds market interest rate, called the funds rate, adjusts according to the supply of and demand for reserves.

    If a bank chooses to borrow emergency reserve funds from a Reserve Bank, then it pays an interest rate called the discount rate. This was lowered by one-half percent in late August in reaction to the “credit crunch”.

    The “discount rate” is the interest rate that a regional Reserve Bank charges banks and financial institutions when they borrow funds on a short-term basis.

    The discount rate often plays a larger role in the overall monetary policy than would be expected because it is a visible announcement of change in the Fed’s monetary policy. This is the most talked about rate and can affect your mortgage and credit card rates.

    The Fed more often alters the supply of reserves available by buying and selling securities. All of this buying and selling is referred to as open market operations.

    Source: HowStuffWorks, Lee Ann Obringer

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