The Federal Reserve and Monetary Policy
About This Lesson
The Fed's tools for managing the economy turn up on the exam in predictable ways, and most of the points come down to one thing: knowing which direction each lever pushes. By the end of this chapter you will know what the Federal Reserve does, its three monetary tools, how monetary policy differs from fiscal policy, and the handful of interest rates the exam expects you to keep straight.
What you'll cover
- what the Federal Reserve is and the tools it uses
- open market operations, the discount rate, and reserve requirements
- monetary policy versus fiscal policy
- the fed funds, discount, prime, and call loan rates
This rounds out the economics portion of the capital-markets material.
The Federal Reserve & Its Tools
The Federal Reserve, almost always just called "the Fed," is the central bank of the United States. It is not a commercial bank and it is not part of the securities industry, but its decisions ripple straight into interest rates, the broader economy, and the markets you will spend the rest of this course studying. It does this through monetary policy: its control over the money supply and the cost of borrowing.
The Fed has three main levers for steering the money supply and interest rates. One does almost all the day-to-day work; the other two are used more rarely but are still fair game on the exam.
1. Open market operations (the workhorse)
This is the tool the Fed reaches for constantly. Through the Federal Open Market Committee (FOMC), the Fed buys and sells U.S. government securities in the open market:
- To stimulate the economy (an expansionary move), the Fed buys securities. It pays cash to the sellers, which injects money into the banking system, expands the money supply, and pushes interest rates down.
- To cool the economy (a contractionary move), the Fed sells securities. That pulls money out of the system, shrinks the money supply, and pushes interest rates up.
2. The discount rate
The discount rate is the rate the Fed charges banks that borrow directly from it at the so-called discount window. Raising it makes that borrowing more expensive, so banks borrow and lend less (tighter money); lowering it does the reverse (easier money).
3. Reserve requirements
The reserve requirement is the share of customer deposits a bank must hold back rather than lend out. Raising the requirement leaves banks less to lend, which tightens money and tends to lift rates; lowering it frees up lending, which loosens money and tends to ease rates. This is the bluntest of the three tools, and it is changed rarely.
Same chain, opposite direction. The trigger (buying vs. selling) sets everything else in motion. Note that bond prices move opposite to interest rates: this chain is why. The SIE frequently asks about downstream effects: e.g., “If the Fed buys securities, what happens to bond prices?” Answer: rates fall → bond prices rise.
When the Federal Reserve purchases government securities on the open market, what is the expected effect?
The Federal Reserve wants to stimulate economic growth. Which action would the FOMC most likely take?
Monetary vs. Fiscal Policy
One distinction the exam returns to again and again is monetary policy versus fiscal policy. They are easy to confuse, but they come from completely different places. Monetary policy is the Fed's domain, the money supply and interest rates. Fiscal policy belongs to Congress and the President, and it works through taxes and government spending. Fiscal policy is emphatically not the Fed.
| Monetary Policy | Fiscal Policy | |
|---|---|---|
| Controlled by | Federal Reserve (the Fed) | Congress and the President |
| Tools | Open market operations, discount rate, reserve requirements | Taxation and government spending |
| Stimulative action | Lower rates, buy securities, lower reserves | Cut taxes, increase spending |
| Restrictive action | Raise rates, sell securities, raise reserves | Raise taxes, decrease spending |
| Goal | Price stability and maximum employment | Economic growth and public services |
The shortcut: if a question mentions the Fed, the FOMC, or interest rates, it is monetary policy. If it mentions Congress, taxes, or government spending, it is fiscal policy.
Key Interest Rates
A handful of interest rates show up on the exam, and the trick is keeping straight who charges whom. Walk them in order:
- The federal funds rate is what banks charge each other for overnight loans of excess reserves. The FOMC sets a target for it, and it is the single most watched rate in the economy.
- The discount rate is what the Fed charges banks that borrow directly from it at the discount window. It usually sits a bit above the fed funds rate, since borrowing straight from the Fed is meant to be a last resort.
- The prime rate is what banks charge their most creditworthy customers. It moves in lockstep with the fed funds rate and typically runs about three percentage points above it.
- The call loan rate (or broker call rate) is what banks charge broker-dealers for the money behind margin loans. The broker-dealer then charges its customers that rate plus a spread.
The prime rate is most accurately described as:
Which of the following statements correctly distinguishes the discount rate from the federal funds rate?
Chapter Essentials
The Fed runs monetary policy with three tools: open market operations (the FOMC buying or selling government securities, by far the most used), the discount rate (what the Fed charges banks at the discount window), and reserve requirements (how much banks must hold back). The one direction never to get backward: the Fed buys to stimulate (money supply up, rates down) and sells to cool things off (money supply down, rates up).
Keep fiscal policy (Congress and the President, working through taxes and spending) separate from monetary policy. And among the rates, remember who charges whom: banks charge each other the fed funds rate, the Fed charges banks the discount rate, and banks charge their best customers the prime rate.
The reliable gotchas in this chapter:
• Fed buys to stimulate, sells to slow down. Buying securities injects money and lowers rates (expansionary); selling drains money and raises rates (contractionary). Getting this backward is the single most common mistake on Fed questions.
• Monetary policy is the Fed; fiscal policy is Congress. If a question mentions taxes or government spending, it is fiscal policy and has nothing to do with the Fed. If it mentions the FOMC, interest rates, or the money supply, it is monetary.
• Discount rate versus fed funds rate. The discount rate is what the Fed charges banks borrowing directly from it; the fed funds rate is what banks charge each other overnight. They are not the same, and the discount rate is normally the higher of the two.
• Open market operations are the everyday tool. Reserve requirements are powerful but blunt and rarely changed. If a question asks for the Fed's most commonly used tool, the answer is open market operations, not the reserve requirement.
• The prime rate is a bank rate, not a Fed rate. Banks set the prime rate for their best customers; the Fed does not set it directly. It just tends to track the fed funds rate, usually about three points higher.
Monetary vs. fiscal policy, the Fed's tools, and key interest rates, all in one place.
Test yourself with exam-style questions on this topic.