4) The Federal Reserve: Monetary Policy

What happens when interest rates are reduced? While many debtors will most likely rejoice at this welcome news, the fact is that it will have an adverse affect on the economy. If more people or companies will borrow money because of the lower cost of credit, the changes to the amount of money and credit will affect the economy to the point of instability. It is therefore the task of the Federal Reserve to influence the amount of money and credit in the US economy through monetary policy.

The goals of monetary policy, as you may know, are sustainable growth, stable prices and full employment. It is through monetary policy that the Fed tunes the economy to the right levels.

The Tools

There are three main tools in which the Federal Reserve can influence monetary policy:

The first one is by setting the Discount Rate (interest rate) that banks pay on short-term loans from the Fed. This is an obvious indicator of change in the Fed’s monetary policy. It also gives the market an insight into the plans of the Fed. The discount rate is lower than the Federal Funds Rate most of the time.

The second tool is Open-Market Operations. This is the tool frequently used by the Fed to influence monetary policy. By buying and selling US government securities in the financial markets continuously, this influences the level of reserves in the banking system. This in turn affects the volume and the price of credit (interest rates). The choice by which the Fed decides which primary securities dealer to do business with is based on an open market where the various dealers compete.

Last is by setting the Reserve Requirements. All banks, or depository institutions, are required to hold a certain amount of physical funds in reserve against deposits in bank accounts. This determines the volume of money created by banks through loans and investments. A typical bank doesn’t usually hold $1 billion worth of deposits within its vaults. Instead, it lends most of the money out, and this is how a bank makes profit too. Excess reserves are also deposited in accounts with the district Federal Reserve Bank. The Board of Governors of the Fed commonly puts reserve requirements at 10%.

The Federal Funds Rate

The Federal Funds Rate (FFR) is the rate at which banks borrow reserves from each other. This rate is handled by the Federal Open Market Committee (FOMC), although it does not directly dictate the actual rate itself. The open market determines the actual rate instead. This is why the use of open-market operations is very important to the Fed because it affects the FFR. The fluctuations of the FFR also impacts all the other interest rates charged by US banks.

You might wonder why banks have to borrow reserves from one another? On normal daily operations, many banks will fall below the reserve requirements, and in order to fulfill the requirement, they have to borrow from each other’s reserves. This borrowing and lending of reserves creates a market in reserve funds.