The Fed’s Monetary Policy Tools

Course: Investment Planning
Lesson 2: Tools of the Fed

Student Question:

How does the Fed impact monetary policy by using “Interest on Reserve Balances?”

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Instructor Response:

One of The Federal Reserve’s (FED’s) core functions is to balance the health of the American economy between inflation and recession.  The FED uses Interest on Reserve Balances (IORB) as a primary monetary policy tool in that role.  Changes in the IORB influence the Federal Funds Rate (FFR).  The FFR is the interest rate that banks charge other institutions for lending excess cash to them from their reserve balances on an overnight basis.  Increases in the IORB tend to result in increases to the FFR and vice versa.  The bigger picture here is why does the Fed change IORB?

• Increasing the IORB rate tends to encourage member banks to deposit more money with the FED, potentially lessening the member bank’s lending to customers.  We may see this when the member bank can earn a greater return from the IORB than from loans to customers.  Making fewer loans or, drastically, calling existing loans reduces the money supply and is contractionary to the economy (anti-inflationary)—it tends to dampen economic activity. 
• In contrast, the Fed’s decreasing the IORB tends to encourage banks to make more loans to customers rather that making deposits with the Fed.  More loans increase the money supply which tends to stimulate the economy.