Understanding the Policy Tools of the Fed
The Fed has three traditional policy tools to implement monetary policy: (1) the Fed Funds rate; (2) the discount rate and (3) reserve requirements.
To understand these tools you must first understand a bit about how banks operate. Banks must keep deposits at the Federal Reserve (more about this below under the section describing reserve requirements and more here). The exact amount of deposits that each bank must hold depends on how much money is deposited in the bank during the week; some banks find they have extra deposits at the Fed, while others have too little. The market for these deposits is called the Federal Funds market, usually referred to as Fed Funds. The Fed owns a portfolio of Treasury securities; by buying or selling these securities, the Fed can increase or decrease the amount of money deposited at banks; these transactions are called open market operations.
In practice, the Fed Funds rate is the tool that the Fed uses most often; by intervening in the Fed Funds market (via open market operations) the Fed can raise or lower the interest rate charged by banks for loans to other banks. In recent years (with the exception of the period starting in the last few months of 2007) Fed policy could be characterized by the Fed Funds rate. When the economy appeared to be slowing the Fed would cut rates (Fed Funds were 1% in Summer 2003) and when the economy appeared to be expanding too rapidly the Fed would raise rates (Fed Funds were 5.25% in Summer 2006). As this tool became the center of much attention a Fed Funds futures market was created; traders can bet on the Fed Funds rate and other investors can use the price of these futures as a guide to the market’s expectation of future Fed policy (see here for the futures contract and here for an interpretation of the prices of Fed Funds futures and options).
The discount rate is not really used as a policy tool during normal times. The Fed wants banks that have temporary liquidity problems to be a bit reluctant to borrow directly from the Fed, preferring that instead they borrow from other banks. Maintaining a modest spread (normally 100 basis points; see here for transcripts of discount rate decisions of the last few years) between the discount rate and the Fed Funds rate discourages use of the discount window for a bank who is not having problems. But this meant that markets started to believe that if a bank used the discount window then the bank was having problems, so banks avoided using the discount window. In normal times, when the banking sector is profitable, this is not really a problem. But during the subprime crisis banks that had problems obtaining short-term finance (because they had big positions in risky mortgage securities, other banks were reluctant to lend them funds) still avoided the discount window, even when the gap between the discount rate and the Fed Funds rate was reduced in August to 50 basis points and several prominent banks borrowed money from the discount window. This led the Fed to create the auction funds from a “Term Auction Facility” (see here for more), that essentially provided discount rate loans with potentially smaller penalties as a way to get funds into the system.
Reserve requirements had been a policy tool of the Fed in the past but are no longer used for policy purposes. The Fed requires banks and other financial institutions to keep 10% (approximately, see here for details) of transactions accounts (essentially checking accounts) in vault cash or on deposit at the Fed or another institution. There have been modest changes to the reserve requirement rules in the last 25 years in ways that seem unrelated to policy concerns.