The function of the Fed most discussed in the popular press is that of conducting monetary policy. In an ongoing process, the Fed tinkers with the availability of money, using several different tools described below.The Fed has the authority to set the reserve requirements observed by depository institutions.
In doing so, it proscribes the portion of a bank’s deposits which must be held in reserve, and not extended as loans to DSU’s. Because of the process of deposit expansion, where the reserve requirement determines how much of a deposited dollar remains available for a loan, higher requirements reduce the funds available for loans, and thus make money less available in the economy.
A lower reserve requirement frees up funds from unproductive reserves, and makes money more available in the economy. It is currently the view of the Fed that frequent tinkering with the reserve requirement would destabilize financial markets, and so it is the least frequently used tool of monetary policy.
A change in the discount rate is a change in the interest rate at which the Fed loans money to depository institutions, generally to tide them over short-term liquidity problems. Like the prices for anything else, banks will borrow more from the Fed if the discount rate has been lowered, and will borrow less if the discount rate has been raised. This tool is normally not used often, and is of limited efficacy because banks have other sources of loans besides the Federal Reserve. Because of this, a change in the discount rate has as much effect as a signal of Fed policy, as it does as a genuine price change.