[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Reserve Requirements Finally, the Fed establishes how much banks must
hold as reserves. The reserve requirements are its third tool. If the Fed increases
reserve requirements, banks must set aside a larger fraction of their deposits as
reserves and thus can lend out less. A rise in the reserve requirement reduces the
money multiplier and reduces the impact that a change in the level of reserves has
on the money supply. A reduction in the reserve requirement increases the money
multiplier and increases the effects of a dollar change in reserves on the money supply.
Wrap-Up
INSTRUMENTS OF MONETARY POLICY
1. Reserve requirements—the required ratio of reserves to deposits. The Fed
can change the amount banks must hold as reserves. Increasing the reserve
ratio forces banks to hold a larger fraction of deposits as reserves.
2. Discount rate—the rate that the Fed charges member banks on borrowed
reserves. An increase in the discount rate raises the opportunity cost of borrowing
from the Fed. As a result, banks reduce their borrowing and total
reserve supply falls.
3. Open market operations—purchases and sales of Treasury bills by the Fed.
When the Fed buys government bonds from the public, the stock of reserves
is increased. When the Fed sells government bonds to the public, the stock of
reserves falls.
Selecting the Appropriate Tool Of its three tools, the Federal Reserve uses
open market operations most frequently. The effects of changes in the discount rate
and in reserve requirements are inexact compared with the fine-tuning that open
market operations make possible. Thus, the former are used infrequently, primarily
to announce major shifts in monetary policy. Such changes can be quite effective
in signaling the advent of tighter conditions (that is, higher interest rates and
reduced credit availability) or looser conditions (that is, the reverse). Banks foreseeing
a tightening of credit may cut back on their lending and firms may postpone
their planned investment.
The Stability of the
U.S. Banking System
The fractional reserve system explains how banks create money. It also explains
how, without the Fed, banks can get into trouble. Well-managed banks, even before
the establishment of the Fed and its reserve requirements, kept reserves equal to some
average expectation of day-to-day needs. A bank could soon face disaster if one day’s
needs exceeded its reserves.
630 ∂ CHAPTER 28 MONEY, THE PRICE LEVEL, AND THE FEDERAL RESERVE