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Tools of Federal Reserve Board July 14, 2010

Posted by petrarcanomics in Role of Government.
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Federal Reserve Board Chairman Ben Bernanke
Federal Reserve Board Chairman Ben Bernanke

Open market operations – the process of the Fed buying and selling bonds and securities from its member banks. Expansionary open market operations involves the Fed buying bonds and securities from its member banks to increase the amount of excess reserves member banks have to lend to the general public. Contractionary open market operations involves the Fed selling bonds and securities to member banks thereby decreasing the amount of excess reserves member banks have to loan out to the general public. Open-market operations directly affects the federal funds rate which is the interest rate member banks charge each other for short term and overnight loans. Expansionary open market operations lowers the federal funds rate whereas contractionary open market operations raises this key interest rate.

Discount rate – the interest rate that the Fed charges its member banks when member banks borrow money directly from the Fed. Contractionary monetary policy involves the Fed raising the discount rate, making it more expensive for its member banks to borrow money from the Fed. Expansionary use of the discount rate would involved the Fed lowering the discount rate thereby making it less expensive for its member banks to borrow from the Fed.

Reserve requirement – the percentage of a banks reserves that must be kept in reserve rather than its excess reserves which are those moneys that can be loaned out to the general public. For example, if a bank possessed overall reserves of one billion dollars and the reserve requirement was twenty percent, this member bank would have to hold two hundred billion dollars in reserve and would be able to loan out eight hundred billion dollars. Contractionary use of this tool would involved the Fed raising this reserve requirement thereby lowering the amount of excess reserves this member bank would have to loan out to the general public. Expansionary use of this tool would involved the fed lowering the reserve requirement to increase the amount of excess reserves this member bank could loan out.

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