Download Transcript

Economics "Ask the Instructor" Clip 31 Transcript
The Federal Reserve reduced interest rates 11 times in 2001! What tools are available to the FED for
influencing interest rates and for controlling the nation’s money supply?
The FED has three major, sometimes called quantitative, monetary policy tools at its disposal. One is the
discount rate. This is the interest rate that the FED charges banks who borrow reserves from the FED. An increase
in the discount rate discourages banks from borrowing reserves. And remember, banks can’t lend (i.e. create new
money) unless they have excess reserves. Second, the FED controls the required reserve ratio—that’s the
percentage of a bank’s deposits that must be held as reserves. By changing this fraction, or ratio, the FED can cause
banks’ excess reserves to either increase or decrease.
Far and away, the most important policy tool, at least in terms of the frequency of use, is the Open Market
Operations. This involves the FED either buying or selling government securities in the open market. As you
know, government securities are just another name for U.S. Treasury bonds. Bonds are just U.S. Government debt.
This debt was incurred any time that Congress chose to spend more than it collected in taxes. Bonds are a liability
of the Treasury, but an asset to banks or anyone else that owns them.
Let’s see how open market operations might work. Suppose, for example, that the FED believes economic
activity is slowing and wants to stimulate the economy. It would like to see consumers and businesses spend more.
But assume that banks have no excess reserves and therefore can’t lend. If you wanted to get a loan to buy a new
car or refrigerator, you would not be able to do so because the banks have zero excess reserves.
What could the FED do? It could buy government securities from your bank, paying for them with
reserves. Most likely the FED would pay your bank by increasing your bank’s reserve account at the FED.
Specifically, the reserve account would be at one of the 12 regional Federal District Banks.
What has the FED accomplished by using Open Market Operations? Well, your bank’s assets have
changed. Your bank now has fewer bonds, i.e. fewer government securities. But, and this is important, your bank
now has excess reserves. As a result your bank is now able to lend and will probably offer loans at lower interest
rates. Assuming people borrow, new money will be created and additional spending will occur.
In summary, the FED has three major policy tools. It would probably be a good idea if you reviewed the
effects that each of these has on the balance sheets of both the FED and of the banking system. Assume first that the
Fed’s goal is to stimulate a sluggish economy. Then do the opposite. Assume that the FED wants to reign in an
over heater economy.
Without question, monetary policy is an important stabilization tool. During 2001, the FED used Open
Market Operations an unprecedented 11 times to increase banks’ reserves, which in turn drove-down short-term
interest rates. It also cut the discount rate. The effect was to make it easier for people and businesses to borrow and
to borrow at lower interest rates.