The government has two tools that it can use to try to influence the direction of the economy. Monetary policy created by the Federal Reserve Board and controls cash flow. Fiscal policy is controlled by the President and determines government spending and taxation.
The Federal Reserve Board will try to steer the economy through the business cycle by adjusting the level of money supply and interest rates. The Fed may:
- Change the reserve requirement for member banks
- Change the discount rate charged to member banks
- Set target rates for federal fund loans
- Buy and sell US Government securities through open market operations
- Change the amount of money in circulation
Member banks must keep a percentage of their depositor’s assets in an account with the Federal Reserve. This is known as the reserve requirement. The reserve requirement is intended to ensure that all banks maintain a certain level of liquidity. Banks are in business to earn a profit by lending money. As the bank accepts accounts from depositors, it pays them interest on their money. The bank, in turn, takes the depositors’ money and loans it out at higher rates, earning the difference. If the Fed wanted to stimulate the economy, they might reduce the reserve requirement for the banks, which would allow the banks to lend more. By making more money available to borrower’s interest rates will fall and, therefore, demand will increase, helping to stimulate the economy. If the Fed wanted to slow down the economy it might increase the reserve requirement. The increased requirement would make less money available to borrowers. Interest rates would rise as a result and the demand for goods and services would slow down. Changing the reserve requirement is the least used Fed tool.
Changing the Discount Rate
The Federal Reserve Board may change the discount rate in an effort to guide the economy through the business cycle. Remember, the discount rate is the rate that the Fed charges member banks on loans. This rate is highly symbolic, but as the Fed changes the discount rate, all other interest rates change with it. If the Fed wanted to stimulate the economy, it would reduce the discount rate. As the discount rate falls, all other interest rates fall with it, making the cost of money lower. The lower interest rate should encourage borrowing and demand to help stimulate the economy. If the Fed wanted to slow the economy down, it would increase the discount rate. As the discount rate increases all other rates go up with it, raising the cost of borrowing. As the cost of borrowing increases, demand and the economy slow down.
Federal Open Market Committee
The Federal Open Market Committee (FOMC) is the Fed’s most flexible tool. The FOMC will buy and sell US Government Securities in the secondary market in order to control the money supply. If the Fed wants to stimulate the economy and reduce rates, it will buy government securities. When the Fed buys the securities, money is instantly sent into the banking system. As the money flows into the banks, more money is available to lend. Because there is more money available, interest rates will go down and borrowing and demand should increase to stimulate the economy. If the Fed wants to slow the economy down it will sell US Government securities. When the Fed sells the securities, money flows from the banks and into the Fed, thus reducing the money supply. Since there is less money available to be loaned out, interest rates will increase, slowing borrowing and demand. This will have a cooling effect on the economy.