Central Bank’s Tools to Save Our Economic
1) Interest rates
Interest rates are immediately familiar to everyone because they impact all of us. In the United States Central Bankers set what is known as “The Fed funds rate”, with market forces controlling the wider scope of interest rates such as rates paid on loans or rates received on savings deposits.
Interest rates are but one mechanism for The Fed to control the money supply.
2) Reserve requirements
As part of normal business, banks accept deposits from savers and pay interest to borrowers. Thus, deposited funds can reenter the monetary system as a result of the loan process.
However not all funds deposited at bank may be lent out. In order to insure the stability each institution as well as of the financial system as a whole, regulators demand banks hold a fixed percentage of their assets - a “reserve requirement” - in liquid form. This insures that when savers wish to withdraw funds, their money will be available regardless of the banks loan activities. By increasing or decreasing this percentage - - the money supply can be indirectly controlled.
3) Capital requirements
By law banks must have minimal amount of capital; that is, a specific amount of money underlying the institution. This capital is intended to insure stability of bank as an ongoing concern. Note that this money is above and beyond any sums entrusted to the bank by customers. This is the banks own money, and by increasing or decreasing this minimum amount - known in the business as a “capital requirement” - the money supply can be indirectly controlled.
4) Open Market Operations
A very direct mechanism for influencing the money supply, Central Bankers inject or remove funds by purchasing securities from the open market. This trading activity is known as “Open Market Operations”, generally involve the purchase or sale of US Government Securities. Open Market Operations are very common, and sometimes take place in a coordinated manner. For example, many G7 Central Bankers have worked together in the past to attempt to control the US Dollar or the appreciation of the Japanese Yen.
5) The Discount Window
Banks having short term need of funds can approach The Fed for a loan; this lending facility is known as “The Discount Window”, and it has been in use since the early twentieth century.
But borrowing institution must pledge collateral - usually Government Securities or high quality corporate bonds - and the term of the loan is typically for one day only.
6) Lender of last resort
While not a traditional tool in the sense that it’s commonly used, The Federal Reserve currently and has always stood ready as “lender of last resort”, operating in the best interests of the American economy by insuring that financial institutions always have access to funds under any circumstances.
In rare circumstances the Federal Reserve may also compel the sale or liquidation of struggling institutions.
But some fear that existing tools - although tried and true - won’t be enough. And in response to these concerns, in an attempt to calm the markets and help assuage fears of all market participants, The Fed has deployed some rather powerful new tools.
Tags: Central Bank
