442 CHAPTER 14|ECONOMIC AND SOCIAL POLICY
the economy and prices might rise too quickly.^16 In contrast, if enough money isn’t
available, a recession could occur.
Perhaps the most obvious targets of monetary policy are interest rates. Chang-
ing interest rates aff ect the economy by making borrowing money either less or
more expensive. Businesses and consumers are more likely to borrow if the inter-
est rate is 6 percent than 12 percent. Consumer purchases of big-ticket items,
things that are fi nanced by borrowing rather than purchased with cash, also
increase when interest rates are low and 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.
What can the Fed do to meet its targets on credit availability, the money sup-
ply, and interest rates? There are three central tools of monetary policy. First, the
reserve requirement is the most potentially powerful tool for aff ecting the avail-
ability of credit: banks are required to have a certain amount of money in reserve
to ensure they have cash on hand to cover withdrawals. By simply changing the
amount of money that banks are required to hold for every deposit, the Fed can sig-
nifi cantly infl uence the amount of money that banks can lend. However, because
changing the reserve requirement has such a powerful impact on the economy, the
Fed has rarely used this tool.^17
T he second monet a r y pol ic y t ool , i nt eres t rat es , i s more d i ffi cu lt t o m a n a ge t h a n
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 directly sets. It is the rate the Fed charges to member banks for
shor t-term loa ns. However, it is fa r less impor ta nt a s a policy tool tha n the federal
funds rate (FFR), the rate that member banks charge one another on overnight
loans (these are short-term loans that banks use to meet their reserve require-
ments). Beginning in 1995 the FFR has been the central interest rate target for the
Fed.^18 The FFR is set by the demand for overnight loans that are necessary to settle
accounts, but the Fed greatly aff ects those rates.
Despite the Fed’s ability to infl uence short-term interest rates, it has only indi-
rect impact on long-term interest rates, including consumer rates such as those
for mortgages and home equity loans. The market sets these rates. If an investor
thinks that infl ation will increase from 3 percent to 6 percent over the next fi ve
years, he will demand a higher interest rate for lending his money to the govern-
ment or a cor poration t ha n i f he t h i n k s i n fl ation will hold steady at about 3 percent.
The last tool the Fed uses to meet its monetary targets is open market
operations—the buying and selling of securities. This is the most important tool
because it infl uences the FFR and the level of bank reserves—and thus the money
supply. If the Fed wants to increase the money supply and put downward pressure
on the FFR, it will purchase securities such as government bonds from a bank.
The bank gives the Fed its bond, and the Fed deposits the appropriate amount of
money into the bank’s account at the Fed. The bank can use this money to support
new loans. Open market operations may also serve to contract the money supply
or raise interest rates; if this is the desired outcome, the Fed will sell government
securities. The member bank will give the Fed money to cover the cost of the bond
and therefore take money out of circulation.
Fed chair Ben Bernanke used these tools to help stop the “credit crunch” that
emerged with the meltdown of the subprime mortgage market and related prob-
lems in the bond markets in 2008. The Fed increased its balance sheet (its state-reserve requirement The mini-
mum 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
bank.
open market operations The
process by which the Federal
Reserve System buys and sells
securities to infl uence the money
supply.