Section 12.7 — Federal Reserve Tools & Interest Rates

  • Regulation T (Margin Requirements)

    • Set by the Federal Reserve Board (FRB).

    • Determines how much investors must deposit when buying securities on margin.

    • Current initial deposit: 50% of the purchase price (since 1974).

    • If the FRB lowers the margin requirement → investors can borrow more → stock prices rise → economic expansion.

    • If the FRB raises the margin requirement → limits borrowing → slows the economy.

Reserve Requirement:

  • The % of deposits that banks must keep on hand (with the Fed).

  • Lowering the reserve requirement → banks have more money to lend → expands the economy.

  • Raising the reserve requirement → banks have less money to lend → contracts the economy.

  • Banks that fall below their required reserves can borrow from the Fed (often through a repo).

Repurchase Agreements (Repos)

  • Short-term loans (often overnight) between the Fed and banks.

  • The bank provides assets (like loans) as collateral.

  • The interest rate the Fed charges banks for these short-term loans is the discount rate.

Discount Rate:

  • The rate the Fed charges banks for borrowing directly from the Federal Reserve.

  • Raising the discount rate → slows the economy (tightens credit).

  • Lowering the discount rate → stimulates the economy (eases credit).

  • The discount rate = base rate for the nation.

Rates

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Rates 〰️

Monetary Policy

  • Easy Money Policy (to expand economy / fight recession):

    1. Buy U.S. government securities in the open market.

    2. Lower the discount rate.

    3. Lower reserve requirements.
      👉 Makes credit cheaper and more available.

    Tight Money Policy (to fight inflation / slow expansion):

    1. Sell U.S. government securities in the open market.

    2. Raise the discount rate.

    3. Raise reserve requirements.
      👉 Makes credit more expensive and less available.

Interest Rates & the Cost of Money

  • Interest = the cost of borrowing money.

  • Determined by supply and demand of available credit:

    • If money supply > demand → interest rates fall.

    • If demand > supply → interest rates rise.

Benchmark Interest Rates:

  • Federal Funds Rate

    • Rate banks charge each other for overnight loans of $1 million+.

    • Most volatile rate.

    • Reflects short-term rate direction.

  • Prime Rate

    • Rate large U.S. banks charge their most creditworthy corporate borrowers.

    • Follows FRB policy:

      • Lowered when Fed eases money supply.

      • Raised when Fed tightens.

  • Broker Call Loan Rate (a.k.a. Call Loan or Call Rate)

    • Rate banks charge broker-dealers for money loaned to margin customers.

    • Callable in 24 hours.

  • Discount Rate

    • Only rate directly controlled by the Fed.

    • Decreasing rate = Easy money policy.

    • Increasing rate = Tight money policy.

✺ Review questions ✺

  • A) 25%
    B) 50%
    C) 75%
    D) 100%
    ✅ Answer: B) 50%

  • A) Contracts the economy
    B) Expands the economy
    ✅ Answer: B) Expands the economy

  • A) Prime Rate
    B) Federal Funds Rate
    C) Discount Rate
    D) Call Loan Rate
    ✅ Answer: C) Discount Rate

  • A) Easy money policy
    B) Tight money policy
    ✅ Answer: B) Tight money policy

  • A) Prime Rate
    B) Federal Funds Rate
    C) Discount Rate
    D) Broker Call Loan Rate
    ✅ Answer: B) Federal Funds Rate

  • A) Discount Rate
    B) Federal Funds Rate
    C) Prime Rate
    D) Broker Call Loan Rate
    ✅ Answer: A) Discount Rate

  • A) Credit tightens; economy slows
    B) Credit expands; economy grows
    ✅ Answer: B) Credit expands; economy grows