Source: Principles of Macroeconomics textbook, Ch. 13
Tags: Federal Reserve, Fed, central bank, monetary policy, open market operations, reserve requirements, discount rate, federal funds rate, interest on reserves, FOMC, Board of Governors, monetary base, expansionary policy, restrictive policy
Difficulty: Intermediate
Prerequisites: Parts 1 and 2 of these notes (functions of money, M1/M2, fractional reserve banking, deposit multiplier). You need to understand how banks create money before you can understand how the Fed controls the process.
The Federal Reserve is the institution that controls the U.S. money supply. Created in 1913, it sits at the centre of the banking system and uses several tools to expand or contract the amount of money circulating in the economy. This section covers the Fed's structure, its four main policy tools, how those tools interact with the banking system's deposit multiplier, and why measuring the money supply has become more complicated in recent decades. Grasping these tools is essential for the chapters on monetary policy, interest rates, and aggregate demand that follow.
The Fed controls the money supply using four tools: reserve requirements, open market operations, lending to banks, and interest paid on reserves. Open market operations (buying and selling government bonds) are the primary tool. When the Fed buys bonds, reserves flow into banks and the money supply expands; when it sells bonds, reserves drain out and the money supply contracts.
Federal Reserve (the Fed)
The central bank of the United States, created in 1913. It controls the money supply, serves as a lender of last resort for banks, and regulates the banking sector. Think of it as the bank for banks.
Board of Governors
The seven-member body at the centre of Federal Reserve operations, located in Washington D.C. It sets rates and regulations for depository institutions. Members serve staggered 14-year terms to insulate the Fed from short-term political pressure.
Federal Open Market Committee (FOMC)
A 12-member committee that sets policy on buying and selling government securities. It includes the seven Board of Governors members plus five Federal Reserve district bank presidents. The FOMC's decisions drive the most important day-to-day tool of monetary policy.
Open market operations
The buying and selling of U.S. Treasury bonds and other financial assets by the Fed. This is the Fed's primary tool for controlling the money supply. In simple terms, when the Fed buys bonds it puts money into the banking system, and when it sells bonds it takes money out.
Reserve requirements
The fraction of deposits that banks must hold as reserves (vault cash or deposits with the Fed). Changing this fraction changes how much banks can lend from a given deposit base.
Discount rate
The interest rate the Fed charges banks for short-term loans needed to meet reserve requirements. Think of it as the price of emergency borrowing from the central bank.
Federal funds rate
The interest rate charged in the federal funds market, where banks with excess reserves make short-term loans to banks that need reserves. This is the rate the media reports after each FOMC meeting.
Federal funds market
A private market where banks lend reserves to each other overnight. Banks with excess reserves lend to banks that are short. The interest rate in this market is the federal funds rate.
Interest on reserves (IOR)
The interest rate the Fed pays banks on reserves held at the Fed. Introduced in October 2008, it gives the Fed an additional tool: raising IOR encourages banks to hold reserves rather than lend, reducing the money supply; lowering IOR does the opposite.
Monetary base
Currency in circulation plus the reserves of commercial banks (vault cash and reserves held at the Fed). Think of it as the raw material from which the broader money supply is built through the deposit multiplier process.
The Fed consists of 12 regional Federal Reserve district banks, each monitoring commercial banks in its area and assisting with cheque clearing.
The Board of Governors in Washington D.C. oversees the entire system.
The FOMC meets regularly and its post-meeting announcements, particularly about the target federal funds rate, are among the most closely watched events in financial markets.
The Fed is designed to be independent of direct political control, which strengthens its ability to pursue stabilising monetary policy without pressure from election cycles.
Two sources of independence:
Board of Governors members serve 14-year terms, staggered so that no single president appoints a majority.
The Fed funds itself from interest on the bonds it holds, rather than relying on Congressional appropriations.
The Fed sets the fraction of deposits banks must hold as reserves.
Lowering the reserve requirement creates additional excess reserves, letting banks lend more and expanding the money supply.
Raising the reserve requirement forces banks to hold more back, reducing lending capacity and contracting the money supply.
In practice, the Fed rarely changes reserve requirements because even small changes have large effects.
The Fed buys and sells U.S. Treasury bonds (and, since 2008, other securities) on the open market.
When the Fed buys bonds (expansionary):
Bond sellers receive payment (money from the Fed), which increases bank reserves.
Higher reserves give banks excess reserves to lend, expanding the money supply through the multiplier process.
This also pushes the federal funds rate down.
When the Fed sells bonds (restrictive):
Bond buyers pay with money, which is pulled out of the banking system.
Bank reserves fall, reducing lending capacity and contracting the money supply.
This pushes the federal funds rate up.
Note: U.S. Treasury bonds held by the Fed are part of the national debt.
Banks historically borrow from the Fed to cover temporary reserve shortfalls.
The interest rate on these loans is the discount rate.
A higher discount rate discourages borrowing from the Fed, restricting the money supply.
A lower discount rate makes borrowing cheaper, encouraging it, and exerts an expansionary effect.
The discount rate is closely related to the federal funds rate. Both reflect the cost of short-term reserves, but the federal funds rate is set by the private interbank market and the discount rate is set directly by the Fed.
Post-2008 expansion of lending:
Before 2008, the Fed made only short-term discount rate loans, and only to member banks.
Starting in 2008, the Fed began extending longer-term loans and began lending to non-bank financial institutions (insurance companies, brokerage firms) for periods of 5 to 10 years.
These new loan types also inject reserves into the banking system and exert an expansionary effect on the money supply.
The Fed began paying interest on reserves in October 2008.
To expand the money supply: the Fed sets the interest rate on excess reserves very low (possibly zero), giving banks little incentive to park money at the Fed and encouraging them to lend instead.
To contract the money supply: the Fed raises the interest rate on excess reserves, giving banks an incentive to hold reserves rather than lend them out.
Tool | Expansionary | Restrictive |
|---|---|---|
Reserve requirements | Lower them, creating excess reserves, more lending | Raise them, reducing excess reserves, less lending |
Open market operations | Buy securities, injecting reserves into banks | Sell securities, draining reserves from banks |
Extension of loans | Extend more loans to banks, increasing reserves | Extend fewer loans, reducing reserves |
Interest on excess reserves | Reduce rate, encouraging banks to lend | Increase rate, encouraging banks to hold reserves |
The monetary base equals currency in circulation plus commercial bank reserves (vault cash and deposits at the Fed).
The monetary base matters because it is the foundation on which the money supply is built. Currency contributes directly; bank reserves underpin checking deposits via the multiplier.
Before 2008, the Fed controlled the money supply almost exclusively through open market operations involving Treasury securities.
During 2008, the Fed greatly expanded its purchases to include corporate bonds, mortgage-backed securities, and commercial paper, causing the monetary base to rise from $828 billion (Q2 2008) to $2.21 trillion (Q1 2011).
Weak demand for loans due to recession and slow growth.
The Fed had pushed short-term interest rates to near zero, making lending less profitable.
Considerable uncertainty about the economic outlook made banks reluctant to commit to long-term loans.
The U.S. Treasury handles federal government finances. It issues bonds to fund budget deficits. It does not determine the money supply.
The Federal Reserve handles the monetary climate. It does not issue bonds. It is responsible for controlling the money supply and conducting monetary policy.
Exam questions regularly test whether students can distinguish between these two institutions.
Several innovations have made money supply figures less reliable as policy indicators:
Interest-earning checking accounts (early 1980s): Reduced the opportunity cost of holding checking deposits, which changed the composition of M1.
Money market mutual funds (1990s): Many depositors shifted from checking accounts to MMMFs. Because MMMFs sit in M2 but not M1, this undermined comparisons of M1 across time.
Widespread use of the dollar abroad: Roughly half to two-thirds of U.S. currency circulates outside the country. These dollars are counted in M1 even though they are not used domestically.
Electronic payments replacing cash and cheques: Debit cards and electronic transfers have reduced currency demand, further complicating the money supply picture.
Because of these changes, economists now place less emphasis on raw money supply growth rates and instead rely on a combination of indicators to assess monetary policy.
When the media reports that "the Fed raised rates," they typically mean the FOMC announced a higher target for the federal funds rate. The Fed achieves this by selling bonds (draining reserves) through open market operations. The 2008 financial crisis is a case study in all four tools being used aggressively at once, as the Fed slashed rates, expanded lending to non-banks, and began paying interest on reserves for the first time.
"The Fed prints money." The Fed influences the money supply primarily through open market operations and the banking system's multiplier process, not by operating a printing press. Currency production is handled by the Bureau of Engraving and Printing (under the Treasury), though the Fed determines how much currency to order.
"The federal funds rate and the discount rate are the same thing." They are related but distinct. The federal funds rate is the market rate at which banks lend reserves to each other. The discount rate is the rate the Fed charges for its own loans to banks. The discount rate typically sits slightly above the federal funds rate.
"The Fed controls the money supply with a single lever." It has four main tools, and since 2008 it uses all of them in combination. Open market operations remain the primary tool, but interest on reserves has become increasingly important.
"The U.S. Treasury and the Federal Reserve do the same thing." The Treasury handles government spending and borrowing. The Fed handles monetary policy. They are separate institutions with different mandates.
⚠️ Know all four tools of monetary policy and whether each is expansionary or restrictive in a given direction. The summary table above is worth memorising.
⚠️ Understand the mechanism of open market operations step by step: Fed buys bonds → bank reserves rise → excess reserves increase → banks lend more → money supply expands (and vice versa).
⚠️ Be able to distinguish the federal funds rate from the discount rate and explain how they relate to each other.
⚠️ Know the difference between the U.S. Treasury and the Federal Reserve. This is a common exam question.
⚠️ Be prepared to explain why the massive increase in the monetary base after 2008 did not produce a proportional increase in the money supply (banks held excess reserves instead of lending).
True or False: Open market operations are the Fed's primary tool for controlling the money supply.
Fill in the blank: When the Fed buys bonds, bank reserves ________ and the money supply ________.
True or False: The U.S. Treasury is responsible for controlling the money supply.
Fill in the blank: The monetary base equals ________ in circulation plus commercial bank ________.
True or False: Raising the interest rate the Fed pays on excess reserves encourages banks to lend more.
(Answers: 1. True. 2. increase, expands. 3. False, that is the Federal Reserve. 4. currency, reserves. 5. False, it encourages them to hold reserves, reducing lending.)
Q: What are the four tools the Federal Reserve uses to control the money supply?
A: (1) Reserve requirements, (2) open market operations, (3) extension of loans (discount rate lending and longer-term loans), and (4) interest paid on bank reserves.
Q: Explain how open market purchases by the Fed lead to an expansion of the money supply.
A: When the Fed buys government bonds, it pays bond sellers with newly created money. This money enters the banking system as deposits, increasing bank reserves. The excess reserves allow banks to extend new loans, which create new deposits at other banks, triggering the deposit multiplier process and expanding the total money supply.
Q: What is the federal funds rate, and how does the Fed influence it?
A: The federal funds rate is the interest rate at which banks lend reserves to one another overnight in the federal funds market. The Fed influences it through open market operations: buying bonds injects reserves, increasing supply and pushing the rate down; selling bonds drains reserves, reducing supply and pushing the rate up.
Q: Why did banks hold large excess reserves after 2008 instead of lending them out?
A: Three reasons: (1) weak loan demand due to recession and slow growth, (2) near-zero interest rates on short-term lending made loans less profitable, and (3) uncertainty about the future made banks reluctant to make long-term commitments.
Q: Distinguish between the U.S. Treasury and the Federal Reserve.
A: The U.S. Treasury finances federal government expenditures and issues bonds to cover budget deficits. It does not control the money supply. The Federal Reserve manages the monetary climate, controls the money supply through its policy tools, and conducts monetary policy. It does not issue bonds.
Q: Name two reasons economists place less emphasis on money supply growth figures as indicators of monetary policy today.
A: (1) Widespread use of the dollar abroad inflates M1 with currency not circulating domestically. (2) Financial innovations such as money market mutual funds and electronic payments have changed the composition of money aggregates, making them less comparable over time.
The tools described here are the mechanism by which the Fed implements the monetary policy discussed in subsequent chapters (typically Chapter 14 and beyond). Open market operations and the federal funds rate connect directly to interest rate determination and aggregate demand. The post-2008 expansion of the Fed's toolkit ties into discussions of quantitative easing and unconventional monetary policy. The distinction between the Treasury and the Fed is also relevant to fiscal policy chapters.
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