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Maintain the Stability of the Financial System As we have seen, one of the major rea-
The federal funds market allows
sons the Federal Reserve System was created was to provide the nation with a safe and banks that fall short of the reserve
stable monetary and financial system. The Fed is charged with maintaining the in- requirement to borrow funds from banks
tegrity of the financial system. As part of this function, Federal Reserve banks provide with excess reserves.
liquidity to financial institutions to ensure their safety and soundness. The federal funds rate is the interest
rate determined in the federal funds Section 5 The Financial Sector
Conduct Monetary Policy One of the Federal Reserve’s most important functions is
market.
the conduct of monetary policy. As we will see, the Federal Reserve uses the tools of
The discount rate is the interest rate
monetary policy to prevent or address extreme macroeconomic fluctuations in the
the Fed charges on loans to banks.
U.S. economy.
What the Fed Does

How does the Fed go about performing its functions? The Federal Reserve has three
main policy tools at its disposal: reserve requirements, the discount rate, and, perhaps most
importantly, open -market operations. These tools play a part in how the Fed performs
each of its functions as outlined below.

The Reserve Requirement

In our discussion of bank runs, we noted that the Fed sets a minimum required
reserve ratio, currently equal to 10% for checkable bank deposits. Banks that fail
to maintain at least the required reserve ratio on average over a two -week period
face penalties.
What does a bank do if it looks as if it has insufficient reserves to meet the Fed’s re-
serve requirement? Normally, it borrows additional reserves from other banks via the
federal funds market, a financial market that allows banks that fall short of the re-
serve requirement to borrow reserves (usually just overnight) from banks that are hold-
ing excess reserves. The interest rate in this market is determined by supply and
demand but the supply and demand for bank reserves are both strongly affected by
Federal Reserve actions. Later we will see how the federal funds rate, the interest rate
at which funds are borrowed and lent in the federal funds market, plays a key role in
modern monetary policy.
In order to alter the money supply, the Fed can change reserve requirements. If the
Fed reduces the required reserve ratio, banks will lend a larger percentage of their de- Spencer Platt/Getty Images
posits, leading to more loans and an increase in the money supply via the money multi-
plier. Alternatively, if the Fed increases the required reserve ratio, banks are forced to
reduce their lending, leading to a fall in the money supply via the money multiplier. A trader works on the floor of the New
Under current practice, however, the Fed doesn’t use changes in reserve requirements York Stock Exchange as the Federal Re-
serve announces that it will be keeping
to actively manage the money supply. The last significant change in reserve require- its key interest rate near zero.
ments was in 1992.

The Discount Rate

Banks in need of reserves can also borrow from the Fed itself via the discount window.
The discount rate is the interest rate the Fed charges on those loans. Normally, the dis-
count rate is set 1 percentage point above the federal funds rate in order to discourage
banks from turning to the Fed when they are in need of reserves.
In order to alter the money supply, the Fed can change the discount rate. Beginning
in the fall of 2007, the Fed reduced the spread between the federal funds rate and the
discount rate as part of its response to an ongoing financial crisis, described later in
this module. As a result, by the spring of 2008 the discount rate was only 0.25 percent-
age points above the federal funds rate.
If the Fed reduces the spread between the discount rate and the federal funds rate,
the cost to banks of being short of reserves falls; banks respond by increasing their

module 27 The Federal Reserve: Monetary Policy 263