Monetary Policy

The most important function of the Federal Reserve is to conduct the nation’s monetary policy. The Federal Open Market Committee (FOMC) is the Fed policy-making body that meets eight times a year to make monetary policy decisions. It uses its power to change the money supply in order to control inflation and interest rates, increase employment, and influence economic activity. A central bank has the following three traditional tools to implement monetary policy in the economy:

1. Open market operations
2. Changing reserve requirements
3. Changing the discount rate

Open Market Operations

The most commonly used tool of monetary policy in the U.S. is open market operations. Open market operations take place when the Fed sells or buys U.S. Treasury bonds. The U.S. Treasury issues bonds to obtain the extra money needed to run the government if taxes and other revenues aren’t enough. Treasury bonds are essentially long-term loans (five years or longer) made by businesses and individuals to the government. The Federal Reserve buys and sells these bonds for the Treasury. When the Federal Reserve buys bonds, it puts money into the economy. Banks have more money to lend, so they reduce interest rates, which generally stimulates economic activity. The opposite occurs when the Federal Reserve sells government bonds.

Changing Reserve Requirements

Banks that are members of the Federal Reserve System must hold some of their deposits in cash in their vaults or in an account at a district bank. This reserve requirement ranges from 3 to 10 percent on different types of deposits. When the Federal Reserve raises the reserve requirement, banks must hold larger reserves and thus have less money to lend. As a result, interest rates rise, and economic activity slows down. Lowering the reserve requirement increases loanable funds, causes banks to lower interest rates, and stimulates the economy; however, the Federal Reserve seldom changes reserve requirements.

Changing the Discount Rate

The Federal Reserve is called “the banker’s bank” because it lends money to banks that need it. The interest rate that the Federal Reserve charges its member banks is called the discount rate. When the discount rate is less than the cost of other sources of funds (such as certificates of deposit), commercial banks borrow from the Federal Reserve and then lend the funds at a higher rate to customers. The banks profit from the spread, or difference, between the rate they charge their customers and the rate paid to the Federal Reserve. Changes in the discount rate usually produce changes in the interest rate that banks charge their customers. The Federal Reserve raises the discount rate to slow down economic growth and lowers it to stimulate growth.

The Federal Reserve System’s Monetary Tools and Their Effects
Tool	Action	Effect on Money Supply	Effect on Interest Rates	Effect on Economic Activity
Open market operations	Buy government bonds	Increases	Lowers	Stimulates
	Sell government bonds	Decreases	Raises	Slows Down
Reserve requirements	Raise reserve requirements	Decreases	Raises	Slows Down
	Lower reserve requirements	Increases	Lowers	Stimulates
Discount rate	Raise discount rate	Decreases	Raises	Slows Down
	Lower discount rate	Increases	Lowers	Stimulates