What would the effect be if the Fed raised the reserve requirement What if the requirement was lowered?

Tools of Monetary Policy

As the central bank of the United States, the Federal Reserve System has the responsibility of controlling the nation�s money supply. The Fed has three major tools that it can use to affect the money supply. These tools are 1) changing reserve requirements; 2) changing the discount rate; and 3) open market operations. The book discusses these tools of monetary policy on pages 389 - 395.

Changing Reserve Requirements

Banks don�t keep all of their deposits sitting in the vault � they keep some on hand and lend the rest out. The amount that banks keep as cash in the vault is called a bank�s reserves. The Federal Reserve System sets the minimum amount of reserves that a bank must keep. These required reserves are the minimum amount of reserves that a bank is required by law to keep on hand to back up its deposits. Currently, reserve requirements for each individual bank are zero on deposits less than $8.5 million; 3% on deposits between $8.5 million and $45.8 million; and 10% on deposits above $45.8 million.

Suppose that a bank has $10 million in deposits, and is just meeting the Fed�s reserve requirements by keeping $300,000 as cash on hand ($300,000 is 3% of $10 million). Now suppose that the Fed drops the reserve requirement to 2 percent, so that the bank is only required to have $200,000 as reserves. What can the bank do? If it chooses to, the bank can increase its lending by an extra $100,000. If the bank chooses to lend more, the money supply will increase. So by lowering the reserve requirements, the Fed is trying to increase the money supply.

Suppose instead that the Fed raises reserves requirements. Banks will have to cut back their lending in order to keep more reserves on hand to meet Fed requirements. So if the Fed is trying to reduce the money supply, it can raise reserve requirements.

In fact, the Fed rarely changes reserve requirements. There are two reasons for this. One is that changes in the reserve requirements are very powerful � they can cause very big changes in the money supply. In fact, changes in the reserve requirements can be too powerful, can cause too much of a change. A second reason is that if the Fed changed reserve requirements very often, banks would soon ignore these changes. For example, if the Fed lowered reserve requirements to encourage banks to lend more, banks wouldn�t bother to do this if they knew that the Fed might raise reserve requirements back up anytime soon.

Changing the Discount Rate

If a bank doesn�t have enough reserves to meet reserve requirements, it must get those reserves from somewhere. One place a bank can get reserves is by borrowing from the Fed. Of course, whenever a person or a business or an organization borrows, it must pay interest. And a bank that borrows from the Fed must pay interest to the Fed. The interest rate that the Fed charges to banks that borrow from it is called the discount rate. The Fed can change the discount rate to try to change the money supply.

Suppose the Fed lowers the discount rate. That makes it cheaper for banks to borrow from the Fed if they need reserves. So if banks lend out too much of their reserves and need to get more, they can do so cheaply by borrowing from the Fed. Thus a lower discount rate will encourage banks to lend more, which increases the money supply.

On the other hand, suppose the Fed raises the discount rate. Now if a bank lends too much and needs to borrow reserves to meet Fed requirements, it will be expensive to borrow from the Fed. So banks will lend less, so they don�t have worry about the possibility of having to borrow expensive reserves from the Fed. Thus a higher discount rate discourages banks from lending, and as they lend less, the money supply goes down.

So the Fed can use changes in the discount rate to try to influence the amount of lending that banks do, and thus influence the size of the money supply.

But in fact, changes in the discount rate don�t have much effect on how much banks lend. That�s because banks don�t like to borrow from the Fed, regardless of whether the discount rate is low or high. If a bank borrows from the Fed, the Fed might wonder why the bank needs to borrow, and the Fed might ask to see the bank�s records and start checking into how well the bank is being managed. No bank wants that to happen. So while the Fed raises and lowers the discount rate frequently, and while those changes make the news, changes in the discount rate don�t have much effect on banks� lending and therefore don�t have much effect on the money supply.

Banks are much more likely to borrow from each other than from the Fed. Short-term (really short-term, often just overnight) that makes make to another are called federal funds and the interest rate that banks charge each other is called the federal funds rate. These terms will be important in the next section.

Open Market Operations

This is by far the most important and most effective tool of changing the money supply that the Fed has. An open market operation is when the Fed buys or sells U.S. government bonds. (U.S. government bonds are issued by the federal government when it borrows money to cover a budget deficit � so government bonds are IOUs of the federal government. People and banks and other organizations are always buying and selling these bonds.) We�ll need to consider buying and selling separately, because they have different impacts on the money supply. When the Fed buys government bonds, that�s called an open market purchase; when the Fed sells government bonds, that�s called an open market sale.

A Federal Reserve Open Market Purchase

Let�s consider first what happens when the Fed buys government bonds. Suppose that the Fed buys bonds from a bank (the result is the same if the Fed buys bonds from a business or from an individual, but the story is a little easier to tell if we assume the Fed buys bonds from a bank.)

So the Fed buys the bonds, and of course it has to pay for them.

How does the Fed pay for the bonds? By crediting the bank with more reserves. The Fed simply records an extra amount of reserves (an amount equal to the value of the bonds it has bought) for that bank.

Now what do you suppose the bank does with those extra reserves? What the Fed hopes the bank will do is lend out those reserves. And if the bank lends out those reserves, the money supply will increase.

A Federal Reserve Open Market Purchase increases the money supply.

A Federal Reserve Open Market Sale

Suppose that the Fed sells bonds. Again, the story is simpler if we assume the Fed sells those bonds to a bank (but again the results are the same whomever or whatever the Fed sells the bonds to).

So the Fed sells bonds, and of course the Fed wants to be paid.

How does the Fed take payment from the bank? By taking away some of that bank�s reserves.

Now what does the bank do since it has fewer reserves? It will lend less, and that will reduce the money supply.

A Federal Reserve Open Market Sale decreases the money supply.

The Fed engages in open market operations very frequently and with great effect. Open market operations are the primary way that the Fed tries to change the money supply.

Summary

If the Fed wants to increase the money supply, it needs to get banks to lend more. The Fed can do one of three things to encourage banks to lend more. It can lower reserve requirements. It can lower the discount rate. It can buy bonds. Of these three, buying bonds (an open market operation) is by far the most important and most effective way to increase the money supply.

If the Fed wants to reduce the money supply, it needs to get banks to lend less. The Fed can do one of three things to discourage banks from lending. It can raise reserve requirements. It can raise the discount rate. It can sell bonds. Of these three, selling bonds (an open market operation) is by far the most important and effective way to reduce the money supply.

Now the question is, Why would the Fed want to increase or reduce the money supply? The answer appears in the next section.

What happens if the Fed raises or lowers the reserve requirement?

What happens when the reserve requirement increases what happens when it decreases?