Targeting the federal funds rate allows the Fed some ability to control bank reserves and thus the money supply. Explain how each of the following tools allows the Fed to fine-tune its control of bank reserves

Question

a. Conducting open market operations
b. Changing the discount rate
c. The ability to pay interest on reserves
d. The Term Deposit Facility

Answer 1

a. When the Fed conducts an open market purchase, it purchases Treasury securities in the open market, and the money received by the seller of the securities becomes reserves in the banking system. The increase in bank reserves decreases the federal funds rate. An open market sale reduces bank reserves and increases the federal funds rate.
b. When the Fed raises the discount rate, banks must pay more to borrow money from the Fed. This will decrease the number of loans made by the Fed, decreasing the monetary base. All else equal, this will reduce the money supply. If the Fed lowers the discount rate, more loans will be made, increasing bank reserves and the monetary base, and all else equal, this will increase the money supply.
c. By increasing the interest rate on reserves, the Fed can increase the level of reserves banks are willing to hold, thereby restraining bank lending and slowing the growth in the money supply. Decreasing the interest rate will increase bank lending and increase the money supply.
d. By increasing the interest rate on term deposits, the Fed can decrease the level of reserves banks have available to make loans, thereby restraining bank lending and slowing the growth in the money supply. Decreasing the interest rate will increase bank lending and increase the money supply.