What do Banks Do?

1. What do banks do? 2. What are the tools of the Fed?

We have not yet said very much about exactly how the Fed changes interest rates. The Fed has three major tools at its disposal: open-market operations, the reserve requirement, and the discount rate. We discuss these in turn. Monetary policy operates through the Fed’s interactions with the banking system, so we first must make sure we understand what banks do in the economy. [1] Throughout this discussion, we use the credit market to think about how the Fed operates. Toolkit: Section 16.4 “The Credit (Loan) Market (Macro)” You can review the workings of the credit market in the toolkit. What Do Banks Do? Financial markets (that is, banks and other financial institutions) provide the link between savings and investment in the economy. A bank is a profit-making entity that takes in deposits from households and firms and makes loans to firms, households, and the government. Banks can be fragile institutions. [2] They must ensure that their depositors are not worried that the bank might go out of business, taking their money with it. Banks do many things to ensure that their customers have confidence in them. Perhaps the most important is that they keep a certain amount of their assets in a very liquid form, such as cash. This means that if a depositor comes in to withdraw his or her money, the bank will be able to meet that demand. These liquid deposits are called the reserves of the bank. Most banks in the United States are members of the Federal Reserve System. This membership comes with a responsibility to hold some fraction of deposits on reserve.

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