Open Market Orders Reserves and the Discount Rate

FEDs and Money

Are CCs and Debit Cards Money?

Credit cards and debit cards are not money but are actually considered tools or financial instruments that facilitate transactions in which money is exchanged. Both types of cards represent a convenient way to access and spend funds in a bank account (or made available to one via a line of credit). Because they are accessing different types of accounts, they act differently (Chand, n.d.).

First of all, what is money? Money is a medium of exchange, a unit of account, and a store of value (Beattie, 2022). It comes in various forms, such as cash, coins, or digital currency (Chand, n.d.). Debit cards are linked to a bank account, and when you make a transaction using a debit card, the money is directly withdrawn from your account. The transaction is made using the funds you already have, so it can be thought of as an electronic form of cash—but the main point to remember here is that this is money that is yours, not someone else’s, and it is drawn directly from your account.

Credit cards, on the other hand, allow you to borrow money from the card issuer (usually a bank) to make a purchase. When you use a credit card, you are basically taking out a short-term loan that you agree to pay back later, often with interest if not paid in full by the due date.

In both cases, the cards themselves are not money, but rather, they represent a means of accessing and using the money in your accounts or through borrowed funds.

When the Fed Makes an Open Market Purchase

“When the Fed makes an open market purchase of government securities, the quantity of money will eventually decrease by a fraction of the initial change in the monetary base.” This statement is incorrect. When the Federal Reserve (Fed) makes an open market purchase of government securities, the quantity of money will typically increase, not decrease. The statement seems to have confused the impact of an open market purchase with that of an open market sale (Amadeo, 2021).

Open market operations are one of the tools the Fed uses to implement monetary policy. When the Fed purchases government securities (e.g., Treasury bonds) from banks and other financial institutions in the open market, it pays for these securities by crediting the reserve accounts of these institutions. This process increases the monetary base, which consists of currency in circulation and reserves held by banks at the Fed.

An increase in the monetary base leads to an increase in the money supply through the money multiplier effect. The money multiplier is the relationship between the monetary base and the money supply, which depends on the reserve requirement ratio and banks' willingness to lend. When banks have more reserves, they can make more loans, creating new deposits in the process, and thereby expanding the money supply.

Ultimately, this process can be inflationary as well, for if the money supply increases rapidly, prices may rise to offset the sudden tidal wave of cash now in everyone’s pocket. This is best illustrated in recent history by the various bubbles in markets that have followed the Fed’s open market operations (also known as quantitative easing or QE): the housing bubble, the stock market bubble, the everything bubble (Amadeo, 2022).

Monetary Policy

The Fed can use several tools to influence the money supply and indirectly affect the level of real GDP. The three main tools the Fed can employ to increase the money supply are open market operations, the discount rate, and reserve requirements. Each of them allows the Fed to perform a different function (Board of Governors of the Federal Reserve System, 2023).

Open Market Operations (OMOs)

Open Market Operations (OMOs) are a key tool used by the Federal Reserve to implement monetary policy. By buying or selling government securities in the open market, the Fed can influence the money supply and interest rates, which in turn affect overall economic activity. When the Fed wants to increase the money supply and stimulate economic growth, it conducts expansionary open market operations by purchasing government securities. Here's a more detailed explanation of the process:

First, the Fed decides to purchase government securities such as Treasury bonds from banks and other financial institutions. These transactions are conducted through the Federal Open Market Committee (FOMC), which is responsible for making decisions about open market operations. Second, when the Fed buys these securities, it pays for them by creating new reserves. These reserves are credited to the reserve accounts of the selling institutions, effectively increasing the amount of reserves in the banking system. This process increases the monetary base, which consists of currency in circulation and reserves held by banks at the Fed.

Now, with more reserves at their disposal, banks are able to extend more loans to businesses and consumers. As banks make more loans, they create new deposits, which leads to an increase in the broader money supply (e.g., M1 or M2). This process is called the money multiplier effect. As a result, the increased money supply puts downward pressure on interest rates, as banks compete to lend their excess reserves. Lower interest rates make borrowing more attractive for businesses and consumers, encouraging them to take out loans for investments, expansions, or purchases (Board of Governors of the Federal Reserve System, 2023).

Finally, as borrowing and spending increase, businesses respond by increasing production and hiring more workers to meet the growing demand for goods and services. This increase in economic activity leads to higher real GDP, which is the measure of an economy's output adjusted for inflation. However, the Fed must carefully monitor the effects of these actions to avoid causing excessive inflation or overheating the economy.

Discount Rate

By adjusting the discount rate, the Fed can make borrowing from the central bank more or less attractive for commercial banks, which in turn affects the availability of credit and the money supply. First, the Federal Reserve sets the discount rate, which is the interest rate it charges on short-term loans provided to commercial banks through the discount window. These loans are typically used by banks to meet short-term liquidity needs or to maintain the required level of reserves. When the Fed lowers the discount rate, borrowing from the central bank becomes cheaper for commercial banks. This encourages banks to take advantage of the discount window and borrow more reserves from the Fed (Board of Governors of the Federal Reserve System, 2023).

Similarly to what happens with OMOs, as banks obtain more reserves from the Fed, their ability to lend to businesses and consumers increases. With more reserves at their disposal, banks can extend more loans, leading to an increase in the overall money supply. It is the same process over again as before—essentially goosing the system to help get a few more miles out of an economy that appears to be stalling.

Reserve Requirements

The Fed can also directly affect the amount of funds available for banks to lend by adjusting reserve requirements. The amount of reserves banks need to have on hand impacts the money supply and interest rates. So what are reserves?

Reserve requirements are regulations set by the Fed that dictate the minimum percentage of deposits that banks must hold as reserves. These reserves can either be held as cash in their vaults or as deposits at the central bank. Reserve requirements act as a safety measure to ensure that banks have enough liquidity to meet their customers' withdrawal demands. When the Fed lowers reserve requirements, banks are required to hold a smaller percentage of their deposits as reserves. This frees up more funds for banks to use for lending to businesses and consumers (Board of Governors of the Federal Reserve System, 2023). Essentially, if the Fed wants to get more money into the market without adding new money to the existing money supply, it can lift reserve restrictions on banks. With more funds available for lending, banks can extend more loans, leading to an increase in the overall money supply, the same as with OMOs and using the discount rate (Board of Governors of the Federal Reserve System, 2023). The increase in the money supply leads to lower interest rates, and lower interest rates attract more businesses and consumers (theoretically). This in turn (theoretically) leads to new economic activity. One problem in all of this is the possibility of zombie companies and zombie consumers simply digging deeper their own graves thanks to easy credit. At some point credit tightens (as is happening now), and the stilts holding up the economy are pulled away.