Now that we have seen what the money supply is and why the money multiplier multiplies a change in reserves, let’s look at the three major tools the Fed uses to control the money supply. These are:

Suppose that the Federal Reserve wants to increase the money supply. How does it do it? As explained earlier, if the Fed wants to create money, it can simply print money or add numbers to bank accounts. But how does the new money find its way into the economy? Imagine, for example, that the Fed added money to its own bank account and bought apples with the new money. At first, the money would flow to apple farmers and then the apple farmers would buy more tractors and television sets and vacations, and the money would flow out to other people who themselves would buy more goods. In this way, the Fed’s increase in the money supply would spread throughout the economy. And if the Fed wanted to reduce the money supply, it could sell some of the apples that it had bought earlier.

The Fed, however, doesn’t want to buy and sell apples. Apples are difficult to store, expensive to ship, and available in very large quantities during only part of the year. So instead of apples, the Fed buys and sells government bonds, usually short-term bonds called Treasury bills or T-bills (these are also often called Treasury securities or “Treasuries”). Government bonds can be stored and shipped electronically and the market for government bonds is liquid and deep, which means that the Fed can easily buy and sell billions of dollars worth of government bonds in a matter of minutes.

So, if the Fed wants to change the money supply, it usually does so by buying or selling government bonds. This is called an open market operation. To pay for the T-bills, the Fed electronically increases the reserves of the seller, usually a bank or a large dealer in Treasury securities. With more reserves on hand, that bank will respond by increasing its loans beginning the ripple process just described. That is, banks will make additional loans, the loans will in turn be used to buy goods and pay wages, and people will deposit some of these payments into other banks. The new deposits will increase the reserves of these other banks, which will now also be able to make more loans. Thus, the purchase of bonds by the Federal Reserve leads to a ripple process of i ncreasing deposits, loans, deposits, loans, deposits, more loans, and so forth.

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We noted earlier that the change in the money supply is equal to the change in reserves multiplied by the money multiplier, ΔMS = ΔReserves × MM. It’s important to remember, however, that the size of the money multiplier is not fixed. The multiplier is the inverse of the reserve ratio and the reserve ratio is determined by banks. When banks are confident and eager to lend, they will want to keep their reserves relatively low so the money multiplier will be large (MM = 1/RR). In this case, changes at the base of the money pyramid (Figure 15.2) have a relatively large effect on the entire pyramid.

But when banks are fearful and reluctant to lend—that is, they wish to hold a high level of reserves—the money multiplier will be low and a change in the monetary base need not change the broader monetary aggregates much at all. In this case, changes at the base of the money pyramid have a relatively small effect on the entire pyramid.

Thus, even though the Fed controls the monetary base, the Fed may not know how much or how quickly changes in the base will change loans and the broader measures of the money supply.

Summarizing, (1) the Federal Reserve can increase or decrease reserves at banks by buying or selling government bonds, (2) the increase in reserves boosts the money supply through a multiplier process, and (3) the size of the multiplier is not fixed but depends on how much of their assets the banks want to hold as reserves.

Open Market Operations and Interest Rates Conducting monetary policy by buying and selling government bonds rather than, say, apples has another advantage. You may recall from Chapter 9 that bond prices and interest rates are inversely related: When bond prices go up, that is another way of saying interest rates go down, and when bond prices go down, that means interest rates go up. Thus, when the Fed buys or sells bonds, it changes the monetary base and influences interest rates at the same time. Let’s go through this in more detail.

When the Fed buys bonds, it increases the demand for bonds, which pushes up the price of bonds, thus lowering the interest rate. So, buying bonds stimulates the economy through two distinct mechanisms, namely higher money supplies and lower interest rates. In a sense, the increase in the money supply increases the supply of loans and the lower interest rates increase the quantity of loans demanded.

When the Fed sells bonds, the process works in reverse. Selling bonds reduces the money supply as people give up their reserves to buy the bonds. Selling bonds also lowers the price of bonds, which means that interest rates increase. Instead of stimulating the economy, an open-market sale of bonds will slow the economy.

When you hear that “the Fed has lowered (or raised) interest rates,” do not be confused. The Fed does not “set” interest rates in the same way that a 7-Eleven owner “sets” the price of milk in the store. Instead, interest rates are determined in a broad market through the supply and demand for loans as outlined in Chapter 9. The Fed works through supply and demand, and if the Fed wants short-term interest rates to fall, it has to buy more bonds, thereby influencing market prices.

Usually, the Fed conducts open market operations by buying and selling the short-term debt of the federal government. Sometimes the Fed wants to influence long-term interest rates and then it might buy longer-term government bonds, or other longer-term securities, in the 10- to 30-year range. This kind of policy is sometimes called quantitative easing and it is used when the economy requires an extra boost, beyond what is available from normal open market operations on short-term securities.

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The Fed Controls a Real Rate Only in the Short Run Lending and borrowing decisions depend on the real interest rate, the interest rate after inflation has been taken into account (see Chapter 12). It’s important to understand, therefore, that the Fed has influence on real interest rates only in the short run. Remember from Chapter 12 that money is neutral in the long run—that neutrality includes real interest rates. Similarly, remember from Chapter 13 that an increase in aggregate demand (AD) increases the real growth rate only in the short run. Thus, the long-run neutrality of money, the long-run neutrality of aggregate demand, and the long-run neutrality of Federal Reserve influence over real rates are all different sides of the same “coin.”

The Fed has the most influence over a short-term interest rate called the Federal Funds rate. The Federal Funds rate is simply the overnight rate (that’s really short term!) for a loan from one major bank to another. Banks lend not only to entrepreneurs, consumers, and home buyers but also to other banks and financial institutions.

Since the Federal Reserve can easily change the reserves of major banks through open market operations, it can exercise especially tight control over the Federal Funds rate. In fact, monetary policy is usually conducted in terms of the Federal Funds rate. For example, instead of deciding to increase the money supply by $50 billion, the Fed might decide to reduce the Federal Funds rate by a quarter of a percentage point—the Fed will then buy bonds until the Federal Funds rate drops by a quarter of a point. Similarly, if the Fed wants to increase the Federal Funds rate, it will sell bonds until the Federal Funds rate increases by the desired amount.

The Fed usually focuses on the Federal Funds rate because it is a convenient signal of monetary policy, it responds very quickly to actions by the Fed, and it can be monitored on a day-to-day basis. In contrast, the broader measures of the money supply, such as Ml and M2, are more difficult to measure and monitor because they require data from many different corners of the banking system. But don’t forget that the Fed controls the Federal Funds rate through its control over the monetary base.

The second tool in the Fed’s toolbox is lending. Remember the more than $2 trillion we discussed in the opening that banks and other financial institutions borrowed in 2008? Now we know why the Fed had the power to make these loans: The Fed can create money at will. Thus, the Fed is often said to be the lender of last resort. When all other institutions have run out of funds or fear to lend, banks and other financial institutions may still turn to the Fed. The Fed’s ability to quickly lend enormous sums in a crisis is a very powerful tool. Let’s see how it works in more detail.

The Fed has several methods of making loans. In normal times, the Fed offers to lend to banks at the discount rate and a bank that borrows from the Fed is often said to be borrowing from the discount window. If banks borrow from the Fed, that increases the money supply. The Fed lends to banks by simply adding extra (electronic) dollars to their accounts at the Fed. These loans increase the monetary base directly, and indirectly they may encourage banks to lend more money, increasing M1 and M2. Of course, when banks pay back these loans, the monetary base shrinks once again. Discount window borrowing therefore tends to be used for short-run “tide-me-overs” rather than for long-run monetary policy decisions.

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Market traders read the discount rate as a signal of the Fed’s attitude or “stance,” namely the Fed’s willingness to allow the money supply to increase. When the Fed lowers the discount rate, the market reads this as signaling an expansionary monetary policy. But, of course, the lower discount rate doesn’t directly affect the monetary base unless banks actually borrow more from the Fed.

Most of the time, most banks are not borrowing from the discount window. It is expected that if a bank is in good health, it will borrow most of its credit needs from other banks or financial institutions, not the Fed. The discount window is intended to help out banks in financial stress when they cannot borrow from the private sector. In fact, if a bank suddenly starts borrowing a lot of money from the discount window, usually it receives a rapid but discreet inquiry from the Fed, asking what exactly is wrong. Banks do not generally want to be in this position.

Nonetheless, all banks know that discount window borrowing is available if they get into financial trouble. For instance, if Citigroup lends money to Wells Fargo, Citigroup knows that Wells Fargo could borrow at the discount window to repay Citigroup, if need be. The very existence of the discount window makes private bank loans work more smoothly, even if it isn’t being used.

Note that the possibility of financial troubles at a bank stems from the very nature of fractional reserve banking. Loans are the main asset of fractional reserve banks, so the value of the bank depends on how willing and able borrowers are to repay their loans.

One potential problem—known as a solvency crisis—occurs when banks become insolvent: The value of a bank’s loans falls so far that the bank can no longer pay back its depositors. Banks usually hold “capital” as a cushion against such losses, but of course the scope of the losses may exceed the capital of the bank. In this context, the use of the word “capital” refers to a very specifically defined legal term, not just to the word “capital” in the general economic sense. The legal formula for bank capital is complex, but the core intuition is that banks are required to hold some of their assets in relatively safe forms in order to provide a protective cushion to shield depositors against potential losses. A bank with a lot of capital is in little danger of defaulting. Internationally coordinated regulations, supported by the Fed, impose capital requirements on U.S. banks.

In 2008, we saw an extraordinary development: The U.S. Treasury acted to “recapitalize” parts of the U.S. banking system. That is, the Treasury invested additional money into these banks to boost their future prospects, in return for the promise that banks would someday repay this investment. The fear was that many U.S. banks were insolvent, due to bad real estate loans and other investment mistakes. This recapitalization was under the authority of the U.S. Treasury, but it was very much an action in conjunction with the Federal Reserve. The goal of recapitalization is to get banks on their feet again and thus get them lending again. Whether or not this action counts as “monetary policy” in the formal sense of that term, it has many of the same effects as monetary policy: in this case, for example, helping to maintain lending and avoid a large decrease in the money supply.

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A second potential problem is called a liquidity crisis. Maybe the bank assets are good, but there is a potential problem if all the depositors want their money back at the same time. A bank might have a lot of good assets on its books, like long-term loans that are repaid over time, but the income from those loans is not available right away. But how do depositors know whether a bank’s assets are good? Often they don’t. As a result, fear can turn solvent banks into illiquid banks very quickly. During the Great Depression, for example, even a rumor that a bank might go under caused depositors to rush to their bank to get their money out before it was too late—thus, causing even good, solvent banks to go under!

To avoid bank runs such as occurred during the Great Depression, the Federal Deposit Insurance Corporation (FDIC) was created. The FDIC guarantees bank deposits up to $250,000 for each depositor name on an account (in practice, the guarantee is often even larger in value). Since depositors know their deposits are insured, they have less reason to run to the bank to withdraw their deposits even if they do hear rumors. Thus, the mere existence of the FDIC can reduce bank panics even if the FDIC never has to pay out.

If despite the FDIC guarantee, many people do want to withdraw their funds, the Federal Reserve System can act as a lender of last resort to help banks meet their obligations. Ideally, the Fed uses the discount window to lend to illiquid (but solvent) institutions and waits for them to regain their liquidity and return to financial health. Of course, in practice, especially during an emergency, it is not always easy to tell which banks are insolvent and which are merely illiquid.

If the Fed knows a bank is insolvent, usually the best thing to do is to pay off depositors and close down that bank before it can incur any further losses. The 2008 Treasury recapitalization of U.S. banks was a break from this traditional practice; the judgment at the time was that too many banks might be insolvent for the economy to survive widespread bank closures, so the Treasury decided to offer aid to banks instead.

The Term Auction Facility During the financial crisis of 2007-2008, sparked initially by problems in the subprime mortgage market (more on this in the next chapter and see also Chapter 9), the Fed went considerably beyond its traditional role in helping out financial institutions.

First, the Fed set up a Term Auction Facility. The Term Auction Facility is best understood in contrast to the discount rate. The discount rate sets an interest rate and then the Fed waits to see how many banks want to borrow. One problem with the discount rate is that banks may not borrow, for fear of admitting to the market that they are in a weak position. The Term Auction Facility had the Fed announce that it wanted to inject a certain quantity of reserves into banks; those funds were then auctioned until the rate was low enough that banks would borrow the money. Furthermore, the Fed loosened collateral requirements for its loans and stressed to banks that there would be no negative stigma from borrowing from the facility. In other words, the Term Auction Facility and related lending activities were designed to give the Fed more control over the money supply, to get around some of the problems just discussed.

The amount of extra lending done by the Fed during the period of the financial crisis was staggering. For instance, between December 2007 and May 2008, the Fed lent approximately $475 billion to the U.S. banking system, mostly to restore liquidity to credit markets. Over the course of the year, the Fed lent over $2 trillion in total. To put that latter figure in perspective, it was over $6,000 for every person in the United States. In addition to all these Fed activities, in 2008 Congress passed a law called the Troubled Asset Relief Program (TARP), which allocated up to $700 billion for the purpose of aiding banks. Fortunately, this money has since been paid back as banks recovered, although critics charge that this bailout put the taxpayers at risk.

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Open market operations and lending are the Fed’s most important tool in normal times, but as of 2008, the Fed has another instrument at its disposal: It can vary the rate of interest that it pays banks on reserves held at the Fed. In previous times, banks received no interest payments on reserves. Not surprisingly, banks wished to minimize those holdings because they brought no profit. In trying to minimize reserves, however, banks sometimes worked at cross-purposes with the Fed, especially when the Fed wanted to make sure that the banking system had plenty of reserves on hand for payment purposes. But now the Fed is paying interest on those reserves, and the Fed consciously varies that interest rate to help achieve the goals of monetary policy.