Chapter 13: Problem 469

What are the five minor tools which the Federal Reserve Board possess?

Short Answer

Expert verified

The five minor tools that the Federal Reserve Board (FED) possesses include: 1. Interest on Reserves (IOR): This is the rate that the FED pays to banks on the idle funds they hold as reserves. Adjusting the IOR can influence the amount of money that banks have available for lending. 2. Margin Requirements: These are the minimum amounts that must be maintained in securities accounts when borrowing to purchase financial assets. Changes in these requirements can affect the amount of credit available for buying securities. 3. Moral Suasion: This involves communication and persuasion by the FED to guide the actions of banks and other financial institutions. 4. Selective Credit Controls: These are directives issued by the FED to impact specific sectors or industries within the economy, influencing lending practices and addressing inflationary or deflationary concerns. 5. Foreign Exchange Intervention: This involves the FED buying or selling foreign currencies to influence exchange rates and stabilize currency fluctuations. While less frequently used than major tools, these minor tools assist the FED in promoting economic stability and growth.

Step by step solution

The Federal Reserve Board (FED) is the central banking system of the United States, responsible for implementing monetary policy. Their primary goal is to promote economic stability and growth by influencing interest rates, controlling inflation, and managing the money supply. The FED has several tools (major and minor) to achieve their objectives. #Section 1: Major Tools of the FED#

Before diving into the minor tools, it's essential to briefly discuss the major tools that the FED uses. The three most commonly used major tools are: 1. Open Market Operations: The buying and selling of government securities in the open market to control the money supply in the economy. 2. Discount rate: The interest rate at which banks can borrow money from the FED. 3. Reserve requirements: The minimum amount of money that a bank must hold as reserves, reducing or increasing the amount they can loan out. Now that we have provided an overview of the major tools, let's move to the discussion of the five minor tools possessed by the FED. #Section 2: Five Minor Tools of the Federal Reserve Board#

1. Interest on Reserves #

Interest on Reserves (IOR) is the rate that the FED pays to banks on the idle funds they hold as reserves. By adjusting the IOR, the FED encourages or discourages banks to hold more or fewer reserves, influencing the money supply available for lending in the economy.

2. Margin Requirements #

Margin requirements refer to the minimum amount of cash or collateral that individuals and businesses must maintain in their securities accounts when borrowing from brokers to purchase financial assets. By altering margin requirements, the FED can influence the amount of credit available for buying securities.

3. Moral Suasion #

Moral suasion involves the FED using communication and persuasion to influence banks and other financial institutions to act in a particular way. Through speeches, press conferences, and meetings, the FED guides market expectations and promotes specific economic behaviors.

4. Selective Credit Controls #

Selective credit controls are directives issued by the FED to influence specific sectors or industries within the economy. These tools can be used to restrict or encourage lending to targeted areas, in turn affecting credit conditions and addressing inflationary or deflationary concerns.

5. Foreign Exchange Intervention #

The FED can intervene in the foreign exchange market by buying or selling foreign currencies. This tool is primarily used to influence exchange rates and stabilize currency fluctuations, which may have an impact on international trade, investment, and the overall economy. In conclusion, the five minor tools used by the Federal Reserve Board to implement monetary policy are Interest on Reserves, Margin Requirements, Moral Suasion, Selective Credit Controls, and Foreign Exchange Intervention. While these minor tools might not be used as frequently as the major tools, they still play a critical role in helping the FED achieve its strategic objectives of promoting economic stability and growth.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Interest on Reserves

One tool the Federal Reserve (Fed) uses to manage the economy is the policy on Interest on Reserves (IOR). Simply put, this interest rate is what banks earn from depositing their excess reserves at the Fed. By tweaking this rate, the Fed influences banks' willingness to lend money. When the IOR is increased, banks are encouraged to hold onto their reserves for a better return, thus tightening the money supply. Conversely, lowering the IOR rate makes holding reserves less attractive, potentially leading to an increase in lending and, therefore, money circulation within the economy.

Especially useful during times of economic downturn, boosting the IOR can be an incentive for banks to stabilize rather than lending out aggressively, which can help prevent inflation. This careful balancing act maintains a healthy flow of money, ensuring neither too much nor too little is available in the market, which could lead to inflation or deflation, respectively.

Margin Requirements

Margin Requirements affect people who want to buy securities (like stocks or bonds) on credit, using money they borrow from a broker. The Fed controls how much money customers must initially put down, known as the 'margin'. This system is akin to a down payment on a house loan, representing a percentage of the purchase. The higher the margin requirement, the less money investors can borrow to buy stocks, which tends to cool off a heated stock market by reducing speculative trading.

For example, if the Fed sets high margin requirements during an economic bubble, it becomes more costly for investors to speculate on stocks because they need more of their own money upfront. This can prevent 'irrational exuberance' in the markets and promote more stable investment practices. Altering the margin requirements is a targeted move that helps control the amount of credit flowing into the stock market.

Moral Suasion

Moral Suasion may sound like a soft tool, but it's a powerful psychological weapon in the Fed's arsenal. The Fed uses its public platform to influence and guide the behavior of banks, investors, and other financial entities through persuasion and appeals to responsibility. This is done by issuing statements, giving speeches, or through media engagements where the Fed expresses its views on the desired direction of financial policies and markets.

The objective here is to mold market expectations and actions without the need for hard regulations or policies. It's like a parent advising a child on responsible spending, with the hope that the advice is taken seriously. If financial institutions believe the Fed might soon adjust policy based on these indications, they might preemptively change their behavior in ways that align with the Fed's goals, such as tightening or loosening credit.

Selective Credit Controls

The Fed has another less commonly used tool at its disposal called Selective Credit Controls. These are targeted measures aimed at managing credit distribution to specific sectors of the economy. For instance, the Fed might want to limit loans to speculative areas, such as real estate, to prevent a bubble, or encourage loans to sectors in need of growth like small businesses.

The essence of these controls is to fine-tune the economy more surgically than the typical broad measures allow, akin to a gardener who prunes a plant to shape its growth, rather than watering the entire garden. It's a way of encouraging or discouraging particular economic activities, helping to soften or inflate specific markets as needed to keep the overall economy balanced.

Foreign Exchange Intervention

Foreign Exchange Intervention is the Fed's strategy of actively entering the foreign exchange market to stabilize the value of the U.S. dollar. By buying or selling significant amounts of foreign currencies in exchange for dollars, the Fed can influence the dollar's exchange rate. When the dollar is too strong, making exports expensive and hurting domestic businesses, the Fed might sell dollars to lower its value. Conversely, to protect the dollar from crashing and triggering inflation, the Fed might buy it back using foreign currency reserves.

This tool is crucial for smoothing out sharp, potentially disruptive, fluctuations in the value of the dollar, which can impact international trade, investments, and the broader global economy. It's the economic equivalent of dampening the waves in a stormy sea to protect the boats (i.e., the global markets) from capsizing.