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Examining how the Fed uses interest rates and open market operations to control the economy.
How can a small group of people in Washington D.C. influence the price of your future car loan or the interest on your savings account without ever touching your bank account directly?
The Federal Reserve’s most frequent tool is Open Market Operations (OMO). This involves the buying and selling of government bonds (Treasuries) in the open market. When the Fed wants to stimulate the economy, it buys bonds from commercial banks. This injects fresh cash into the banking system, increasing the supply of loanable funds. Conversely, to cool down inflation, the Fed sells bonds, pulling cash out of the economy. This process directly targets the Federal Funds Rate (FFR)—the interest rate banks charge each other for overnight loans. By shifting the supply of reserves, the Fed moves the FFR, which then ripples through the entire economy, affecting mortgage rates and credit card interest.
1. The Fed decides to expand the money supply. 2. It purchases 1,000,000 in new digital money. 4. Bank A now has more excess reserves to lend to consumers, lowering interest rates.
Quick Check
If the Fed wants to decrease the money supply to fight inflation, should it buy or sell government bonds?
Answer
It should sell bonds to 'soak up' money from the banking system.
Quick Check
What is the relationship between the reserve requirement and the money supply?
Answer
They are inversely related: a higher reserve requirement leads to a smaller money supply.
Since 2008, the banking system has been flooded with ample reserves. In this environment, traditional OMOs are less effective. Instead, the Fed uses Interest on Reserve Balances (IORB) as its primary tool. This is the interest the Fed pays banks for holding their money at the Fed. If the Fed raises the IORB, banks are more likely to keep their money parked at the Fed rather than lending it to consumers at lower rates. This sets a 'floor' under interest rates. By adjusting the IORB, the Fed can precisely control the market interest rate even when the system is overflowing with cash.
Imagine the economy is facing high inflation. In an 'ample reserves' regime: 1. The Fed cannot easily use OMO to reduce reserves enough to raise rates. 2. Instead, the Fed raises the IORB rate to 5%. 3. Banks realize they can earn a guaranteed 5% from the Fed with zero risk. 4. Banks refuse to lend to businesses for anything less than 5.5% or 6%. 5. Market interest rates rise, spending slows, and inflation is tamed.
When the Federal Reserve purchases government bonds, what is the immediate effect on the federal funds rate?
If the reserve requirement is , what is the money multiplier?
The Interest on Reserve Balances (IORB) acts as a floor for market interest rates.
Review Tomorrow
In 24 hours, try to explain the difference between 'Limited Reserves' (using OMO) and 'Ample Reserves' (using IORB) to a friend.
Practice Activity
Look up the current Federal Funds Rate on the Federal Reserve's website and determine if the Fed is currently pursuing expansionary or contractionary policy.