A Fourth Monetary Policy Tool

by Elaine Schwartz    •    Feb 15, 2010    •    TIME TO READ: 1 minute

The chasm between economics textbooks and real life has grown larger. It is just tough to keep up.

Looking at monetary policy, the most typical tool used by the Federal Reserve takes students so very logically to the Federal Open Market Committee (FOMC). If the FOMC sells securities, they will sink the economy; buying securities buoys the economy. Easy to remember: sell/sink; buy/buoy.

How? When securities are bought, the Fed injects money into the banking system. The Fed gets the securities and the bank gets the money. The result? More excess reserves, more to lend, lower interest rates. For selling securities, the opposite happens. The banks get the securities and the Fed gets the money. Then, banks have less to lend and theoretically, interest rates rise.

Now though, concerned about avoiding inflation but continuing the recovery, Dr. Bernanke says that the Fed will take advantage of a new tool. During October, 2008, the Congress empowered the Fed to pay banks interest on reserves the banks are required to leave with the Fed. Consequently, banks could find it beneficial to hold on to reserves rather than lending them. The result? Fewer dollars chasing goods and restraining inflation.

The Economic Life
Created in 1913, the Federal Reserve is an independent government agency. In charge of monetary policy, traditionally, the Fed has overseen the supply of money and credit in the economy in three basic ways:
1) Discount Rate: by raising or lowering the interest rate it charges banks when they borrow money from it.
2) Open Market Operations: by buying and selling government securities the Fed targets the federal funds rate (the rate banks charge each other)
3) Reserve Requirement: by changing the amount that banks are required to keep in reserve

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