The Fed and Interest Rates

The Federal Reserve (“Fed”) and the Federal Reserve Open Market Committee (FOMC) have the ability to increase or decrease the amount of money in circulation. The Fed uses this power to control the federal funds rate. The federal funds rate is the rate at which banks with excess reserves lend to banks that need to increase their reserves. The federal funds rate is the basis for the establishment of all market interest rates. Thus, by controlling the amount of money in circulation the Fed can manipulate market interest rates.

The fed manipulates the money supply in three ways: open market operations, changing the reserve requirement, and changing the discount rate.

Open Market Operations

The Fed buys and sells U.S. Treasury Securities in the open market to expand and contract the nation’s money supply. When the Fed wants to expand the money supply, it purchases securities from investors in the market. When the Fed wishes to tighten the money supply, it will sell securities in the market. Open market operations affects market interest rates. An expansion in money supply causes interest rates to fall. A contraction in money supply will cause interest rates to rise.

The Reserve Requirement

The Fed can manipulate interest rates by changing the reserve requirement. The reserve requirement requires commercial banks to keep a percentage of their deposits in reserve, rather than lending them in the marketplace. If the Fed increases the reserve requirement, the amount of money in circulation decreases, causing interest rates to rise. In contrast, if the Fed decreases the reserve requirement, the amount of money in circulation increases, driving interest rates down.

The Discount Rate

The discount rate is the interest rate at which banks can borrow money from the Fed (do not confuse the discount rate with the federal funds rate). Low discount rates will entice banks to borrow, effectively increasing the money supply and lowering interest rates. In contrast, banks will try to avoid borrowing from the Fed if the discount rate increases. In the latter case, the amount of money in circulation will decrease and interest rates will rise.

Questions:

1.  Describe the relationship between the money supply, the federal funds rate, and market interest rates.

2.  Describe the three methods the Federal Reserve uses to control the supply of money.

Answers:

-Reference-

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