The Federal Reserve System - Part 2: How the Reserve Regulates Money and the Economy

Part 2: How the Reserve Regulates Money and the Economy

The purpose of the Federal Reserve System (see Part 1 of this series) is to exercise control over the country’s banking reserves. It influences overall monetary and credit conditions, and thus movements in the economy, by actions which affect both the amount and cost of reserves of depository institutions.

Reserves, as defined by law, are cash (in the form of currency and coin) held by depository institutions in their vaults along with the accounts of these institutions at their district Reserve Banks. Total reserves are made up of two components: required reserves, which are defined as the minimum percentage of deposits that the Federal Reserve requires a depository institution to hold against customer deposits (normally ten percent) for the purpose of satisfying customer withdrawal demands. Total reserves minus required reserves are called excess reserves (the second component).

Reserves are provided by the Fed to depository institutions in two forms. Nonborrowed reserves are obtained primarily through Federal Reserve open market operations, which are the buying and selling of U.S. Treasury and federal agency securities. Borrowed reserves are acquired by loan from the Federal Reserve. When borrowed reserves are subtracted from excess reserves, the remaining balance is known as free reserves.

This fractional reserve system is a very powerful tool with which to influence the amount of money and credit in the economy and, therefore, the level of economic activity. For example, if a reserve of ten percent against deposits is required, every dollar of bank reserves held by the Fed could support ten times that amount in deposits in the banking system. For every dollar of excess reserves (which, again, are reserves above those necessary to support the current level of deposits), the banking system can create new deposits and make loans to ten times the amount of the excess reserves. The Fed can significantly affect the banking system’s ability to expand or reduce loans and deposits by acting to increase or reduce reserves.

The Fed can affect the supply of reserves in three ways: 1) by setting bank reserve requirements, which is done by the Federal Reserve Board. This is considered a major step and is not often used.

2) By discount lending. Financial institutions can borrow from the Fed using securities or loans which they own as collateral and paying an interest rate known as the discount rate. This rate is approved by the Board on the recommendation of the district Reserve Banks. Raising or lowering the discount rate can either encourage or discourage borrowing and hence the supply of bank reserves.

3) By open market operations. Directed by the Federal Open Market Committee (FOMC), this is the most frequently used and flexible monetary policy tool employed by the Fed. When the Federal Reserve sells U.S. Treasury securities to securities dealers, the dealers pay with checks drawn on financial institutions. The Fed collects from these institutions by simply reducing their reserve accounts at the Federal Reserve. This method reduces the lending ability of the financial institutions considerably more than the amount of the payment because of the workings of the fractional reserve system (see above). When the Fed buys securities and pays for them by crediting the bank reserve accounts, the opposite effect occurs. These actions indirectly influence the economy through the supply and cost of funds infused or removed from the banking system.

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