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The Federal Reserve and Monetary Policy

The Federal Reserve regulates banks by requiring them to hold a certain amount of their assets as either cash or deposits with the Federal Reserve. Prior to the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) passed in 1980, only banks that were members of the Federal Reserve system had to obey these regulations. National banks, banks that had received their charter from the Comptroller of the Currency, which is part of the U.S. Treasury Department, had to belong to the system. But state banks, which had obtained their charters from state banking authorities, did not have to belong, and most did not. Because the regulations to hold assets that did not earn interest (prior to October, 2008, the Fed did not pay interest on bank deposits) were costly for most banks, most new banks during the 1960s and 1970s were chartered as state banks, and the percentage of deposits held in member banks declined during this period. This decline worried government policy makers and was a major reason for the change in regulations in DIDMCA. Now all financial institutions that issue deposits against which checks can be written are subject to the same reserve requirements.

We saw that banks created money as a by-product of their quest for profit. Banks are limited in the process of money creation by the need to hold some assets in the form of reserves. In the early days of banking, banks needed reserves so that they could redeem deposits or notes on demand. Today the amount of reserves and the form that they take are determined by government regulation. In the United States only vault cash or deposits held at a Federal Reserve Bank can serve as reserves. The amount of reserves that banks must hold is calculated as a percentage of the deposits they hold. This percentage is called the required reserve ratio. In equation form, required reserves are computed as:

(1) Required Reserves = (Required Reserve Ratio)x(Deposits).

Banks can hold more reserves than are required. Any reserves above what are required are excess reserves, or:

(2) Excess Reserves = Legal Reserves - Required Reserves.

In October of 2008 Congress granted the Federal Reserve the authority to pay interest on bank reserves, a seemingly small change that marks a major break in the way the Federal Reserve conducts monetary policy. To consider what the Fed is doing now, it is best to first explain how monetary policy worked before October, 2008.

When reserves earned no interest, banks preferred not to hold excess reserves because in doing so they sacrifice the opportunity to hold other assets that earned interest. Between 1960 and 2008 the amount of excess reserves held in the banking system was only a small fraction of total reserves.1

When banks try to minimize excess reserves, any change in either reserves or in the required reserve ratio will change the amount of deposits people hold, and thus the amount of money in circulation. Banks by themselves can change neither. Although the public can cause changes in both, most changes in them were the result of the Federal Reserve System using three policy tools.

The first policy tool, which has not been used as a tool of monetary policy for decades, is the ability to change the required reserve ratio. If the Federal Reserve increases this ratio, the banking system is forced to destroy money, and if the Federal Reserve decreases this ratio, the system is encouraged to create money.2

Although it too has been a minor policy tool in the past two or three decades, the discount rate is a second policy tool the Federal Reserve possesses. One way a bank can obtain reserves is by borrowing them from the Federal Reserve. When the Federal Reserve charges a high interest rate for these borrowings, banks will not borrow as much reserves as when the Federal Reserve charges a low interest rate.

A third and the only policy tool of importance before October, 2008 was open-market operations.3 In open-market operations the Federal Reserve buys or sells U.S. government securities, usually T-bills, in the secondary market.4 When the Federal Reserve buys securities, it creates the funds with which it buys T-bills. It pays with a check drawn on itself, and when a commercial bank submits this check for payment, the bank gets reserves that did not previously exist.5 The process by which the Federal Reserve creates bank reserves parallels the process by which banks create money. A major difference is that the creation of bank reserve is not a by-product of a quest for profit. On the contrary, any profit is a by-product of an attempt to maintain some level of reserves. Indeed, if a modern central bank set out to maximize profit, it is doubtful that the monetary system could long survive.

In October 2008 the Fed gained and began to use a fourth policy tool, setting interest rates on reserve deposits that banks hold at the Federal Reserve. This policy tool is discussed in a later section.

Decisions about how these tools will be used are reached by twelve voting members of the Federal Open Market Committee (the FOMC). The FOMC meets each month and determines what the monetary policy of the United States will be. This control over monetary policy means that the twelve people who vote on this committee are among the most powerful people in Washington. Seven of these twelve make up the Board of Governors of the Federal Reserve System. The governors are appointed by the President and confirmed by the Senate for 14-year terms. The other five are presidents of the Reserve banks. The president of the Federal Reserve Bank of New York always votes on the FOMC, and the other four positions rotate as one-year terms among the other eleven presidents.

An explanation of monetary policy can be systematically done using balance sheets.

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1Since the 1990s most banks have met their reserve requirements with their vault cash. Three factors that have led to this situation are reductions in reserve requirements, the use of sweep accounts to minimize transactions balances, and the increase in ATMs. If you want more information, here are two places to start: and A bank that had met reserve requirements with cash still needed to hold deposits at the Fed for check clearing, but these deposits were not considered reserves but were classified as contractual clearing balances.

2The Federal Reserve has changed reserve in recent years for various reasons, but these reasons have not included monetary policy. Today reserve requirements are so low that many banks meet them with vault cash.

3Why talk about three policy tools when only one is of any real importance? For two reasons. First, in the past the other two were used. Second, all economic textbooks talk about these three, so to ignore two of them could confuse those who are also using other sources to learn economics. A fourth policy tool that the Fed began using in 2008 is discussed in a later section.

4These transactions are totally distinct from sales of Treasury securities in which the Federal Reserve acts as an agent of the Treasury in marketing its debt. Such sales are into the primary market.

5 The transaction here would be done electronically, with no paper involved. All really large transactions in the U.S. skip the paper.

Copyright Robert Schenk