Reserve Requirements
As a rule, banks are mandated to keep a certain percentage of all deposits in the bank. This is known as the "reserve requirement." The Fed sets the reserve requirement for U.S. banks. By decreasing the reserve requirements, more money is available for the bank to lend out, and the money supply increases.
Interest Rates
The control that a central bank has over interest rates can differ quite a bit from country to country. Contrary to what many believe, the Fed doesn't set the interest rates you pay on your mortgage
(because it can't). That's not to say that the rates the Fed
has control over aren't important -- you can bet that they trickle down to the consumer level.
Domestically, the Fed has direct control over the "discount rate," the rate the Fed charges banks that borrow from it. The Fed also has some level of indirect control over the "federal funds rate," the rate that banks charge each other for overnight federal loans.
Most recently, the Fed lowered the discount rate to 5.75% from 6.25% (see
"Fed Cuts Discount Rate" and
"Fed Plots Measured Course" ), a move that was designed to increase the money supply and add liquidity
to the economy.
How does changing interest rates accomplish that?
From an economic perspective, interest rates are the "cost of money." Therefore, decreasing interest rates lowers the cost of money and increases the money supply. But while adjusting reserve requirements and interest rates are effective ways to change the money supply, their results aren't as quickly seen as is often necessary. That's where open market operations come in.
Jonas Elmerraji
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