What are the 4 Conventional Monetary Policy Tools of the Federal Reserve?

Photo by Joshua Woroniecki on Unsplash

The Federal Reserve has a wide set of policy tools available, visible here on their website, all under the general directive of ensuring stable economic growth.

Of those tools, four are the most central (pun intended) and critical to learn. I like to use the ROID acronym to remember these, as follows:

• Reserve Requirements
• Open Market Operations
• Interest on Reserve Balances
• Discount Window

Reserve Requirements

Reserve requirements are the minimum amount of reserves that banks must keep on hand against their deposits. Reserves can either be held as cash by a bank, or as deposits with the Federal Reserve. Adjust reserve requirements impacts banks’ ability to lend money, which stimulates economic activity. Thus:

• Lowering reserve requirements stimulates economic activity, since banks can issue more loans at better rates.
• Raising reserve requirements forces banks to keep more money in cash and not lend it, which slows economic activity.

Open Market Operations (OMO)

Open market operations involve the Federal Reserve buying and selling government securities in the open (public) market. When thinking about OMO, just track the cash—if cash goes to the Feds, economic activity slows down, which if cash goes to people and businesses, that activity is stimulatory.

• The Federal Reserve buying securities injects liquidity into the banking system, since they purchase these securities from individuals and firms.
• The Federal Reserve selling securities removes liquidity from the banking system, since consumers and firms lock up more money in bonds and the Feds keep the cash.

Interest on Reserve Balances (IORB)

Interest on Reserve Balances, also known as Interest on Excess Reserves or IOR, is the rate that the Federal Reserve pays on the excess reserves that banks hold at the Fed. This tool is most often used to control the federal funds rate.

• Increasing the IORB gives banks an incentive to hold more reserves with the Fed, decreasing the amount of money available for lending and slowing economic activity.
• Decreasing the IORB increases lending and stimluates economic activity and influences short-term interest rates.

Discount Window

The Discount Window is a lending system provided by the Feds to commercial banks and institutions, serving as a safety mechanism to ensure that banks have access to short-term funding throughout periods of financial difficulty (preventing liquidity shortages, essentially).

• The terms and rates set for the Discount Window, set by the Fed, influence banks’ borrowing behaviors.

So, that’s the ROID framework—four core tools used by the Federal Reserve to control the money supply.

Make sure to drop any questions in the comments, and check out my other articles on economics here (useful for studying, or just learning).