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2. Reserve Requirement — The Fed can also adjust the reserve requirement for banks and financial institutions. Lowering the requirement increases the available unlocked cash for the banks, while increasing the reserve requirement ties up more of the cash, resulting in less outflow of money to the public in the form of loans. The Fed is usually reluctant to alter the reserve requirement but it does so on occasion.

3. Discount Rate — The Fed can increase or decrease the rate of interest that banks and financial institutions are charged when they borrow money directly from the Federal Reserve. Banks may borrow money from the Fed for short periods if they meet stringent guidelines and if they are faced with an emergency situation that has brought their reserves below required levels and which cannot be remedied through other means. Lowering the Discount Rate allows the banks to get access to more cash due to a favorable interest rate, while increasing the Discount Rate makes borrowing money from the Fed less palatable; less cash is available as banks shun higher borrowing costs. (Note: The Discount Rate is usually the lowest interest rate available to banks so there are no cheaper alternatives to the Discount Rate.) The Discount Rate is the only rate the Fed can directly modify, and it could have an effect on other interest rates. The Fed changes the Discount Rate very infrequently and usually only under special circumstances. Most banks however do not borrow money from the Fed; instead they borrow from each other. Therefore the Discount Rate is mainly regarded as an indicator for where the interest rates should be. As such the Discount Rate is mainly a symbolic rate, but it is generally kept within half a percentage point (50 basis points) of the more watched Federal Funds Rate, a.k.a. overnight bank lending rate (covered later on).

So let’s consider an example of how the Fed’s implementation of Monetary Policy might affect a specific bank. Bank A (a poor but proud bank) has $3 million in assets of which $1 million is earmarked as …