Federal Reserve Tools: Managing Money Supply and Credit

UPI Study › Courses › Business Essentials › Free lessons › Lesson 23.5 Free with a free account

Federal Reserve Tools: Managing Money Supply and Credit

Business Essentials · Chapter 23: Money and the Federal ReserveSection 23.5 · lesson 101 of 10512 min · free with a free account

← The Federal Reserve System ExplainedNext lesson: The Structure and Players of the U.S. Banking System →

Earn 3 college credits for Business EssentialsRecommended for credit by NCCRS · Business 100 · self-paced · one payment, lifetime access
Enroll in Business Essentials · $250 →Download the syllabus (PDF)

In this lesson

Managing the money supply and credit.

  • Describe the tools of monetary policy
  • Distinguish the policy rate target from a loan rate
  • Trace how a policy action reaches a business
  • Explain the lags and limits of monetary policy

Free study notes

Get this lesson's notes by email

The key points and 4 practice questions with answers, in your inbox. One email, free.

One email. Unsubscribe in one click.

Transcript

Everything said in the video, section by section (1,749 words). Read along, or search it.

Money and the Federal Reserve

Federal Reserve Tools

The Federal Reserve doesn't set interest rates by decree. So how does it actually steer the economy? That's the question for this section, the last in the chapter. This is educational content about monetary policy tools and their effects. It isn't financial, investment, tax, or legal advice. The tools used to implement policy, and the rates and ratios attached to them, have changed over time. So no current rate, ratio, or target is stated anywhere here. The framework should always be verified against a current, authoritative source. We'll cover the tools, and how a policy action travels to a business's own decisions. And we'll be honest about the lags and the limits.

The General Mechanism

From Policy to Prices

Start with the goal. The Fed's mandate is maximum employment and stable prices. To pursue it, policy works along a describable chain. First, the central bank influences the cost and availability of credit. That influences spending and investment, by businesses and by households. And that, in turn, influences output, employment, and prices across the economy. Every tool in this section acts somewhere on that chain. Keep it in mind, because it explains both the tools and their limits. One caution before we start. Since tools and settings have changed over time, check the present framework with a current source.

The Traditional Tools

3 Core Instruments, by Mechanism

Three tools have traditionally been described as the central bank's core instruments. We'll explain each one by its mechanism, not by any current setting. First, open market operations, buying and selling government securities in the open market. When the central bank buys securities, it adds reserves to the banking system. That generally eases conditions, and puts downward pressure on short-term rates. When it sells securities, it removes reserves. That generally tightens conditions, and pushes rates up. Second, the discount window. The central bank lends directly to banks, generally at a rate above the ordinary market rate. It's a backstop source of funds, the lender of last resort role from the previous section. Third, reserve requirements, which could in principle be adjusted to change how much of each deposit banks may lend. But the same caution applies here as before. That framework has changed, and ratios have been set to zero at points. So no current ratio is stated, and any figure you meet should be verified.

Now Generally Used

A Changed Framework, and a Target

Here's where an older textbook picture can mislead. The tools actually used to implement policy day to day have changed over time. Interest paid on reserve balances, and other administered rates, have become central. They're how a policy rate target is maintained in the framework now generally used. That's a shift away from the traditional emphasis, on adjusting the quantity of reserves through open market operations alone. And because this framework can change again, any description, including this one, should be checked against a current source. Now an essential distinction. The policy rate is generally a target. The central bank works to achieve it through its tools. It doesn't set it by decree. And that target isn't the rate a business sees quoted on its own loan. A real loan rate adds the term, credit risk, and liquidity premiums we met earlier, specific to that borrower. So a shift in the target shifts the environment in which every actual rate is set.

Direction, Not Setting

Expansionary Versus Contractionary

Policy is usually described by its direction and intent, not by a particular setting. Expansionary policy is intended to ease credit conditions, and support spending and investment. It's generally used when growth is weak, or unemployment is rising. Or when inflation is running persistently below target. Contractionary policy is the opposite. It's intended to tighten credit conditions and restrain spending. It's generally used when inflation runs persistently above target. Or when the economy shows signs of overheating. Notice what's not here. There's no fixed rule saying which conditions trigger which direction. That's a matter of ongoing policy judgment, made case by case.

Unconventional Tools

When Conventional Tools Hit a Limit

Sometimes conventional tools reach a practical limit. For example, the policy rate target may already have been cut about as far as it can reasonably go. Then unconventional tools come into play. We'll name them as a category. The first is large-scale asset purchases. That means buying securities in substantial quantities, beyond the ordinary scale of routine open market operations. The aim is to influence longer-term rates and broader financial conditions directly. Conventional tools mainly target short-term rates. The second is forward guidance. That means communicating the likely future path of policy, explicitly and in advance. It's the communication tool from the previous section, used in a more deliberate, extended form. The goal is to shape expectations and behavior now, before any further conventional action is taken.

Figure 23.5.1

The Transmission Mechanism

A policy action doesn't change business investment and consumer spending directly, or instantly. It travels through five channels, each with its own speed and strength. First, bank lending rates. Banks adjust the rates they charge, as the cost and availability of funds changes. Second, credit availability. Banks adjust their willingness to lend, the factors we met with the multiplier. Third, asset prices. The value of existing bonds and other assets adjusts to the new rate environment. That's the bond price relationship we met with bond financing. Fourth, exchange rates. Holding the currency becomes more or less attractive, so its value shifts. Fifth, expectations. Businesses and households adjust their plans, based on what the action and its communication signal about the future. These channels don't work in isolation. They combine, each contributing part of the eventual effect. And the full effect only arrives after a long and variable lag. That overall lag is much longer than the fastest single channel would suggest.

Timing

Long, Variable Lags, and What to Watch

That lag is the central practical difficulty of monetary policy. It's long, because the channels move at different speeds, and their combined effect takes considerable time. And it's variable. Its length changes with economic conditions, with confidence, and with factors no one can fully predict. Put those together, and policy has to act on forecasts of future conditions, not only on present data. A policymaker who waits for clear evidence of a problem is often already too late. By then, the problem has been developing for a while. So what should a business take from this? It can usefully watch the direction of policy, and the communication around it. Both carry real information about the credit and demand environment ahead. But it should be far more cautious about predicting the precise timing or size of future moves. The practical posture is to plan for a range of plausible conditions. That's the scenario and sensitivity testing from the financial planning chapter, not one confident forecast.

Stated Honestly

What Monetary Policy Can't Do

Monetary policy has real limits. Here are three, stated honestly. First, it influences demand. It can't fix supply constraints. If the problem is a shortage of a specific input, a disrupted supply chain, or a lack of skilled workers, cheaper credit does little. Those constraints have nothing to do with the cost or availability of borrowing. Second, it can't direct credit to particular sectors. A general easing makes credit cheaper and more widely available. But the central bank doesn't control which businesses or industries banks actually lend to. Third, it works poorly when the problem is unwillingness to borrow, rather than the cost of borrowing. That's the binding constraint we met with the multiplier. If weak confidence makes people reluctant to take on debt, however cheap it gets, cutting rates accomplishes little. The constraint was never really about price in the first place.

A Contested Question

How Effective Is Monetary Policy?

Those limits feed a genuinely contested question. How effective is monetary policy overall? Here are both positions, at full strength. One position says monetary policy is a powerful, reasonably reliable tool for managing overall economic activity. It points to the transmission mechanism we just traced. That mechanism is clear and describable, and it shows policy actions do influence real outcomes over time. The competing position says it's a much blunter, less reliable instrument than the clean diagram suggests. It points to the long and variable lags, and to the limits we just described. It adds that judging, in real time, exactly how much to tighten or ease is genuinely difficult. And it argues that effectiveness varies a lot with the type of economic disturbance being addressed. This course gives no verdict on which description is more accurate.

Table 23.5.1

6 Tools, 6 Limitations

Here are all six tools together, each with its principal limitation. Open market operations are the routine way the policy stance is implemented. But their effect depends on banks actually choosing to lend the resulting reserves. The discount window serves banks facing a temporary shortage of funds. Its weakness is that borrowing from it can be seen as a signal of weakness, which discourages its use. Reserve requirements were historically a core tool. Their current use needs verifying. They're blunt, affecting the whole banking system uniformly, regardless of any one bank's condition. Interest on reserves and administered rates are central to the framework now generally used. Their effectiveness depends on the specific rate structure in effect, which should also be verified. Large-scale asset purchases come in when conventional tools reach a limit. They're less precisely targeted. And forward guidance works alongside other tools. It only works if it's seen as credible, and likely to be followed. This table describes mechanisms, not the current setup. For that, go to a current, authoritative source.

Case Vignette

Planning on a Direction That Didn't Hold

Salvador runs a home renovation contracting firm. This is a composite case, constructed for instruction. Recent public commentary convinces him that a sustained period of policy easing is coming. So he expands aggressively. He hires more crews, and commits to a larger equipment lease. He's positioning ahead of the demand he expects as credit loosens. Instead, conditions shift. Policy tightens, rather than easing further. Salvador is left with extra capacity and commitments, and the demand he planned for hasn't appeared. With his financial adviser, he sees his mistake. He treated a plausible direction as if it were a confident, specific forecast. Given the uncertainty in policy and its lags, no one, not even policymakers, could have known how conditions would evolve. His trade-off is real. Positioning early can be a competitive advantage, but committing too heavily is risky. And a contractor can't avoid making commitments before demand is certain. So going forward, he'll plan around a range of plausible conditions, not a single policy path. He'll keep flexibility, like shorter equipment leases, and phased hiring, so he can adjust if conditions surprise him. That completes our look at money and the Federal Reserve. Next, we turn to the banks a business deals with directly.

About Business Essentials at UPI Study

Business Essentials (Business 100) is a self-paced online course of 105 video lessons in 24 chapters, from the business environment, economics and global markets to ownership, management, leadership, operations, people, marketing, accounting, finance and banking. It carries a NCCRS credit recommendation for 3 semester credits.

Every lesson transcript is free on pages like this one, and the videos are free with a free UPI Study account. Enrolling adds a practice quiz after each lesson, the graded work and final exam that earn the credit, lifetime access, and an official transcript on completion. UPI Study has helped over 130,000 students with college credits. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.

Enroll now → Course details Download the syllabus All Business courses Every course with PRO →

Compare: Business Essentials vs Principles of Management

Why take it here

Why students take Business Essentials with UPI Study

How a business works, end to endBusiness Essentials is a survey of how companies work: economic systems, global trade, forms of ownership, management and leadership, operations, human resources, marketing, accounting, finance and the banking system. It is a common first course in business, management and accounting degrees.
Credit at a fraction of the priceThe same 3 credits can cost $750 or more at a US college. Here it is one payment, self-paced, with lifetime access.
Finish your degree soonerTransfer credits reduce the courses you still owe, so you can graduate earlier or lighten a heavy semester.
Strengthen an applicationA completed college-level course on an official transcript shows admissions and scholarship committees you can do the work.
Study on your own scheduleNo start dates, no deadlines. Watch the lessons, practice, and take the final when you are ready.
130,000+students helped with college creditsACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.

Where the credit goes

Universities that work with NCCRS

Business Essentials carries a NCCRS credit recommendation. These universities work with NCCRS; some are UPI Study's signed partners. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.

Thomas Edison State UniversityThomas Edison State UniversitySigned partnerUniversity of the PeopleUniversity of the PeopleSigned partnerCharter Oak State CollegeCharter Oak State CollegeSigned partnerStrayer UniversityStrayer UniversitySigned partnerColumbia Southern UniversityColumbia Southern UniversitySigned partnerIndiana TechIndiana TechSigned partnerPenn StatePenn StateWorks with NCCRSSouthern New Hampshire UniversitySouthern New Hampshire UniversityWorks with NCCRSSUNYSUNYWorks with NCCRS +many more cooperating universitiesFind my college →

Find my college → Not listed? Ask Athena in the corner of this page, or book a 15-minute call.

FAQ

Questions students ask us

About Federal Reserve Tools: Managing Money Supply and Credit

What are the Federal Reserve's traditional monetary policy tools?
Three tools have traditionally been described as the core instruments. Open market operations buy or sell government securities: buying adds reserves and eases conditions, while selling removes reserves and tightens them. The discount window lends directly to banks, generally at a rate above market rates, as a backstop. Reserve requirements set how much of each deposit banks must hold, though the Fed cut US ratios to zero in March 2020.
How does the Federal Reserve influence interest rates today?
The Fed does not set loan rates by decree; it sets a target range for its policy rate, the federal funds rate, and uses tools to keep the rate within that range. In the framework now generally used, interest paid on reserve balances and other administered rates are central, a shift from relying mainly on changing the quantity of reserves. A business's own loan rate then adds term, credit risk, and liquidity premiums.
What is the difference between expansionary and contractionary monetary policy?
Expansionary monetary policy aims to ease credit and support spending and investment, and is generally used when growth is weak, unemployment is rising, or inflation runs persistently below target. Contractionary policy aims to tighten credit and restrain spending, and is generally used when inflation runs persistently above target or the economy shows signs of overheating. No fixed rule decides which applies; it is a matter of ongoing policy judgment.
What are the limits of monetary policy?
Monetary policy influences demand but cannot fix supply constraints such as input shortages, disrupted supply chains, or a lack of skilled workers. A general easing cannot steer credit to particular sectors, because banks decide whom to lend to. It also works poorly when people are unwilling to borrow, however cheap credit gets. Its effects arrive after long and variable lags, so policymakers must act on forecasts rather than present data alone.

About the Business Essentials course

How many college credits is Business Essentials?
Business Essentials (Business 100) carries a NCCRS credit recommendation for 3 semester credits. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.
How much does Business Essentials cost and what is included?
$250, paid once, with lifetime access: all 105 video lessons, a practice quiz after each, the graded work and final exam, and an official transcript when you finish. Students who want several courses choose UPI Study PRO instead.
Which universities accept UPI Study credits?
UPI Study has signed partner agreements with universities such as Thomas Edison State University, University of the People and Charter Oak State College, and works with universities such as Penn State, SNHU and SUNY. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities. Use "Find my college" on this page to check yours.
How long does Business Essentials take?
It is self-paced with no deadlines. The 105 lessons total about 24 hours of video; most students add reading and practice time and finish in a few weeks to a few months, on their own schedule.
How are the exams done?
Quizzes and assignments are online in the course. The final exam is taken online with proctoring; a person on the UPI Study team checks assignments, usually within two days.
How do my credits reach my college?
When the course shows 100% complete, request the official transcript from your dashboard. It is sent to the college you name, and you can send it to more than one. Check your college first with "Find my college" on this page, or ask Athena.

Ready for the full course? Earn 3 credits in Business Essentials.

105 video lessons, a quiz after each one, and the graded work that earns the credit. Recommended for credit by NCCRS.

Enroll in Business Essentials →Download the syllabusEvery course with PRO →
Business Essentials
3 credits · NCCRSEnroll →