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How a Central Bank Executes Monetary Policy

Monetary policy operates through a complex mechanism, but the basic idea is simple. The Fed supplies (or withdraws) reserves to the banking system, which affects the availability of credit generally. (It might be helpful to refer back to “How Banks Create Money” or this video about the money multiplier in the previous module for a review.)

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A central bank has three traditional tools to implement monetary policy in the economy:

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First, recall the way banks work. They accept deposits from individuals and businesses, a portion of which they hold as reserves. The remaining deposits are lent out, either as loans or to the government by purchasing Treasury securities.

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Every business day, banks receive new deposits and existing depositors make withdrawals. This means that the bank’s reserves go up and down. Some days a bank ends up with more reserves than required by the Fed. These are called excess reserves. Other days the bank ends up with fewer reserves than required. This is a problem that needs to be addressed quickly.

One option is to enter the federal funds market. The federal funds market is not affiliated with the federal government. Rather, it is a private market where commercial banks go to lend excess reserves for a 24 hour period to other commercial banks with a reserve shortfall. The federal funds rate is the interest rate on these overnight, interbank loans. The federal funds rate is possibly the best indicator of credit conditions on short term loans, and changes in credit conditions are quickly reflected by changes in the federal funds rate. We will see the importance of this later.

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The Federal Reserve was founded in the aftermath of the Financial Panic of 1907 when many banks failed as a result of bank runs. As mentioned earlier, since banks make profits by lending out their deposits, no bank, even those that are not bankrupt, can withstand a sufficiently long bank run. As a result of the Panic, the Federal Reserve was founded to be a “lender of last resort.” In the event of a bank run, sound banks (banks that were not bankrupt) could borrow as much cash as they needed from the Fed’s discount “window” to quell the bank run. The interest rate banks pay for such loans is called the discount rate. (They are so named because loans are made against the bank’s outstanding loans “at a discount” of their face value.) Once depositors became convinced that the bank would be able to honor their withdrawals, they no longer had a reason to make a run on the bank. In short, the Federal Reserve was originally intended to provide credit passively, but in the years since its founding, the Fed has taken on a more active role with monetary policy.

Borrowing from the Fed is an alternative to borrowing in the federal funds market for commercial banks that find themselves short of required reserves. This option created the opportunity for the Fed to more actively conduct monetary policy by raising or lowering the discount rate. If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserves from the Fed, and instead borrow from the federal funds market, or for more serious needs, call in loans to replace those reserves. The net effects of raising the discount rate will be a decrease in the amount of reserves in the banking system. Fewer reserves will support fewer loans; the money supply will fall and market interest rates will rise. If the central bank lowers the discount rate it charges to banks, the process works in reverse.

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In the Federal Reserve Act, the phrase “…to afford means of rediscounting commercial paper” is contained in its long title. Changing the discount rate was seen as the main tool for monetary policy when the Fed was initially created.

In recent decades, the Federal Reserve has made relatively few discount loans. Before a bank borrows from the Federal Reserve to fill out its required reserves, the bank is expected to first borrow from other available sources, like other banks. This is encouraged by Fed’s charging a higher discount rate than the federal funds rate. Given that most banks borrow little at the discount rate, changing the discount rate up or down has little impact on their behavior. More importantly, the Fed has found from experience that open market operations are a more precise and powerful means of executing any desired monetary policy. This is a good example of how monetary policy has evolved and how it continues to do so.