558558 Chapter 15 | Economic Policydeterminant of economic activity and inflation. If there is too much money chasing too
few goods, there could be inflationary pressure on the economy and prices might rise
too quickly.^47 In contrast, if there isn’t enough money available, a recession could occur.
Perhaps the most obvious targets of monetary policy are interest rates. Changing
interest rates affects the economy by making borrowing money either cheaper or more
expensive. Businesses and consumers are more likely to borrow if the interest rate is
6 percent than if it is 12 percent. Consumer purchases of big-ticket items, those things
that are financed by borrowing rather than being purchased with cash, also increase
when interest rates are low. These purchases dry up when interest rates are high. That is
why so many appliance stores and car dealers advertise: “Zero dollars down, and zero
percent interest until next January!” Entire sectors of the economy, such as housing,
construction, consumer durables, and cars, are very sensitive to interest rates.Tools of Monetary Policy What can the Fed do to meet targets it sets on credit
availability, the money supply, and interest rates? It uses three central tools of
monetary policy. The reserve requirement is the most obvious and potentially
powerful tool for affecting the availability of credit, but it isn’t used as often as the other
two tools. Banks are required to have a certain amount of money in reserve to make
sure they have cash on hand to cover withdrawals. If everyone decided to take all their
money out at once, the banking system would collapse, because banks are required to
have only 10 percent of all deposits on reserve.
By simply changing the amount of money that banks are required to hold for every
deposit, the Fed can have a big impact on the amount of money that banks can lend.
For example, requiring banks to hold 15 percent of all deposits in reserve instead of 10
percent would contract the amount of money those institutions could lend, whereas
dropping the requirement to 5 percent would have the opposite effect. However,
because changing the reserve requirement has such a powerful impact on the economy,
the Fed has rarely used this tool.^48
The second monetary-policy tool, interest rates, is more difficult to manage than
the reserve requirement. With the reserve requirement, the Fed simply announces the
change in the rate. With interest rates, there is only one rate—the discount rate—that
the Fed sets directly. This is the rate that the Fed charges member banks for short-term
loans. However, it is far less important as a policy tool than the federal funds rate (FFR),
the rate that member banks charge one another on overnight loans, which are short-
term loans that banks use to meet their reserve requirements. Beginning in 1995, the
FFR has been the central interest rate target for the Fed.^49 The FFR is set by the demand
for overnight loans that are necessary to settle accounts, but the Fed greatly affects
those rates.
To make this process clearer, let’s go back to our example of the enterprising
campaign consultant who got the $100,000 loan. If the bank that gave the loan also
had some unexpected withdrawals during that business day, its “vault cash” at the end
of the day may have been short of the 10 percent reserve requirement. The bank would
have to go to the federal funds market and borrow money from a bank that had excess
reserves on that given day. This process of borrowing and lending allows money to flow
smoothly throughout the banking system. If reserves are tight all around the country,
the price of the short-term loans will be bid up and the FFR will rise. If this happens,
the Fed can inject more reserves into the system to keep the FFR at its target (we will
explain how in the next section). The FFR has a broad impact on the economy because
many short-term interest rates track the FFR quite closely. Despite the Fed’s ability to
influence short-term interest rates, it has only an indirect impact on long-term interest
rates, including consumer rates such as mortgages and student loans. Long-term rates
are set by the market—specifically by the expectations of the bond market for inflation.reserve requirement
The minimum amount of money that
a bank is required to have on hand to
back up its assets.discount rate
The interest rate that a bank must pay
on a short-term loan from the Federal
Reserve Bank.
federal funds rate (FFR)
The interest rate that a bank must pay
on an overnight loan from another
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