In the United states, the Fractional Reserve Banking system holds a fraction of deposits as a reserve and only a certain amount will be able to be withdrawn. The federal reserve sets requirements that the bank must hold. This is done by using the fractional-reserve banking system, monetary policy goals which include, open market operations and the discount federal funds target rate. In this paper, I will explain the process of how the FED’s manage money for the economy and the tools they use. I will do this by providing examples of three methods they use. The three methods I chose are Open Market Operations or OMO for short. The second one I chose is Discount and Federal Funds Target Rates. The last one I will be talking about is the Fractional-Reserve Banking System.
The Feds use multiple tools to achieve monetary policy goals. Open Market Operations (OMO) is the system that is used when buying and selling government securities, which in return either expands or contracts the money that is in the banking systems. In order for the money to expand the feds buy securities from the bank, which then in return the banks use the money that they gained to put towards loans for individuals and businesses. This process increases the money supply and reduces the interest rates. If the feds were to sell bonds that would take money out of circulation, which would reduce the money amount that is in circulation and interest rates would increase (Investopedia “Open Market Operations”). The amount the government pays for bonds increases the money amount in the economy. “Some of the new dollars are held as currency and some are deposited into banks” (Mankiw)(Pg. 333, principles of Economics eight edition).
Say, for example, the Fed buys a thousand dollars’ worth of bonds, then the money currency is exactly a thousand dollars. So, “the money that is deposited into the banks increases the money supply by more than a dollar because it increases the reserve and allows the bank to create and use more money”. (Mankiw)(Pg. 333, principles of Economics eight edition)
So, for example, the Fed decides to buy a bond and the interest rate goes from six percent to five percent. Sally decides to take a out a new loan and since the interest rate dropped, she will not have to pay a lot back because the transaction lowered the price of money. On the other hand, Jim has a savings account and now with this new interest rate, he will be earning less in his savings account.
Open-market Operations’ are easy for the Fed to conduct. It’s works similar in the way we do banking on a daily basis. The Fed uses Open-market Operations’ to change how money goes into the economy. The Fed can change the money supply by a little or large amount on any given day without having to change any bank regulations or laws. This is why Open-market Operations’ is a favorite of the Fed to use for monetary. (Mankiw) (Pg. 333, principles of Economics eight edition)
The discount rate is the amount of interest on the loans that the feds charge the bank. The higher the discount rate, the lower the money supply is and the lower the discount rate, the higher the money supply is (PowerPoint Chapter 16, Moodle p.36). The discount rate is also comprised of three different parts. The federal reserve offers primary, secondary and seasonal credit rate. The primary credit rate is only available to places that have a good credit, but the rate is going to be above the usual level of the short-term market rates. These loans are Secondary credit rate is for places that do not qualify for the primary credit rate so in return their rate is going to be higher. Lastly, the seasonal credit rate is for places that experience fluctuations during the year. For these places depending on the time of the year, or season, the higher or lower the rates are going to be and it will be affected by market interests. (Picardo, Elvis. “Discount Rate.”).
The Federal funds rate is an important rate because it affects monetary and financial conditions (Investopedia “Federal Funds Rate”). It is also the amount of interest at which banks make overnight loans to each other. They have a lender, which has excess reserves and borrower, which is the one that needs those reserves. When the federal funds rate changes it causes all of the other interest rates to change also. The federal fund rate is not the same as the discount rate. “The federal fund rate is determined by the supply and demand for loans within banks”. (Quizlet.com)This is targeted by the feds through open-market operations. So, when the feds buy the bonds it decreases the funds rate and increases the money supply. When the feds sell a bond, it increases the federal funds rate and decreases the money supply (PowerPoint Chapter 16, Moodle p.46-48).
No, the discount rate and the Federal funds target rate are not both controlled by the Federal Reserve. The Federal government can control the federal rate, but the Federal government cannot control how much money the banks will need to borrow or lend. The Federal government cannot control what the consumers decide to deposit into banks. (Mankiw)
Fractional Reserve banking is where banks hold only a fraction of deposits as reserves, which in turn the fraction of the reserves that the bank holds is called the reserve ratio. “This ratio is influenced by both the government regulations and by the banks policies”. (Mankiw)(Pg. 328, principles of Economics eight edition).Once there is money in the reserve, there is a required amount that the banks must have and that is set by the Fed (another tool to implement monetary policy). For example, say a bank has deposits of one million dollars and the reserve ratio is twelve percent, the bank would have to have $1,120,000 in reserves. Even though the banks need to have money in the reserves, they can hold reserves over the legal minimum. Now on the banking side, the banks create money (assets and liabilities) and it increases the money supply, but it does not create wealth; it only creates money (PowerPoint Chapter 16, Moodle p. 20-22). If the reserve requirement were to increase, it would take money out of the economy, but if the reserve requirement were to decrease, money would go back into the economy (Investopedia “Reserve Ratio”). This system keeps everything running and money flowing. Say Sally takes out a loan, she gets more money, but she ends up taking on more debt. So, now she’s in debt and not any wealthier. That same concept is behind Fractional-Reserve banking, it creates money for people to have access to, “but it does not make the economy wealthier”. (Mankiw) (Pg. 329, principles of Economics eight edition)
Say, for an example, the bank has five million dollars in reserves. The same amount of money coming into the bank is the same amount of money going out the bank. Instead of just keeping the money in the safe at the bank. The bank could consider lending out some of the money it has in reserves and then charge interest on the loans. Some of the different type of loans the bank could lend are short term loans and long-term loans. The bank could lend money to couples looking to purchase their first house. Couple’s looking to refinance their home. The bank could lend to business’s looking to purchase new buildings. The bank could lend to students that are needing help paying for college. The bank could also lend money to people to buy cars. The bank could lend out personal loans. No matter what the loan maybe for, people are willing to pay the interest to get what the things they want. However, the bank must keep enough in reserves incase depositors want to make withdrawals. (Mankiw) (Pg. 328, principles of Economics eight edition)
In conclusion, The Fed uses a variety of tools to achieve monetary policy goals. Open Market Operations is a favorite of the Feds to use, it allows the Fed freedom on how much they decided to change the money monetary on a daily basis. The Fed decides the interest rates, and this affects how much we as consumers will have to pay back to the banks or other finical institutions for loans and or services. Fractional Reserve banking is important to banks, banks use this method to charge interest rates on services in the form of loans to consumers. The Fed sets requirements the banks must follow. However, the Feds do not control how much the banks lend to consumer’s or how much consumers decide to deposit in banks. (Mankiw)?