{"id":2864,"date":"2023-02-19T16:10:57","date_gmt":"2023-02-19T16:10:57","guid":{"rendered":"https:\/\/content.one.lumenlearning.com\/introductiontobusiness\/chapter\/how-a-central-bank-executes-monetary-policy\/"},"modified":"2023-07-20T21:46:04","modified_gmt":"2023-07-20T21:46:04","slug":"how-a-central-bank-executes-monetary-policy","status":"publish","type":"chapter","link":"https:\/\/content.one.lumenlearning.com\/introductiontobusiness\/chapter\/how-a-central-bank-executes-monetary-policy\/","title":{"raw":"Learn It 4.2.4: The U.S. Banking System","rendered":"Learn It 4.2.4: The U.S. Banking System"},"content":{"raw":"

Monetary Policy<\/h2>\r\nThe most important function of the Federal Reserve is to conduct the nation\u2019s monetary policy<\/span>.\u00a0The 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:\r\n
    \r\n \t
  1. Open market operations<\/li>\r\n \t
  2. Changing reserve requirements<\/li>\r\n \t
  3. Changing the discount rate<\/li>\r\n<\/ol>\r\n

    Open Market Operations<\/h3>\r\nThe most commonly used tool of monetary policy in the U.S. is open market operations. Open market operations<\/strong> 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\u2019t 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.\r\n

    Changing Reserve Requirements<\/h3>\r\nBanks 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<\/strong> 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.\r\n

    Changing the Discount Rate<\/h3>\r\nThe Federal Reserve is called \u201cthe banker\u2019s bank\u201d because it lends money to banks that need it. The interest rate that the Federal Reserve charges its member banks is called the\u00a0discount rate<\/span><\/strong>. 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\u00a0spread,<\/em>\u00a0or 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.\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n
    The Federal Reserve System\u2019s Monetary Tools and Their Effects<\/th>\r\n<\/tr>\r\n
    Tool<\/th>\r\nAction<\/th>\r\nEffect on Money Supply<\/th>\r\nEffect on Interest Rates<\/th>\r\nEffect on Economic Activity<\/th>\r\n<\/tr>\r\n<\/thead>\r\n
    Open market operations<\/td>\r\nBuy government bonds<\/td>\r\nIncreases<\/td>\r\nLowers<\/td>\r\nStimulates<\/td>\r\n<\/tr>\r\n
    Sell government bonds<\/td>\r\nDecreases<\/td>\r\nRaises<\/td>\r\nSlows Down<\/td>\r\n<\/tr>\r\n
    Reserve requirements<\/td>\r\nRaise reserve requirements<\/td>\r\nDecreases<\/td>\r\nRaises<\/td>\r\nSlows Down<\/td>\r\n<\/tr>\r\n
    Lower reserve requirements<\/td>\r\nIncreases<\/td>\r\nLowers<\/td>\r\nStimulates<\/td>\r\n<\/tr>\r\n
    Discount rate<\/td>\r\nRaise discount rate<\/td>\r\nDecreases<\/td>\r\nRaises<\/td>\r\nSlows Down<\/td>\r\n<\/tr>\r\n
    Lower discount rate<\/td>\r\nIncreases<\/td>\r\nLowers<\/td>\r\nStimulates<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n
    [ohm2_question height=\"350\"]3841[\/ohm2_question]<\/section> \r\n\r\n ","rendered":"

    Monetary Policy<\/h2>\n

    The most important function of the Federal Reserve is to conduct the nation\u2019s monetary policy<\/span>.\u00a0The 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:<\/p>\n

      \n
    1. Open market operations<\/li>\n
    2. Changing reserve requirements<\/li>\n
    3. Changing the discount rate<\/li>\n<\/ol>\n

      Open Market Operations<\/h3>\n

      The most commonly used tool of monetary policy in the U.S. is open market operations. Open market operations<\/strong> 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\u2019t 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.<\/p>\n

      Changing Reserve Requirements<\/h3>\n

      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<\/strong> 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.<\/p>\n

      Changing the Discount Rate<\/h3>\n

      The Federal Reserve is called \u201cthe banker\u2019s bank\u201d because it lends money to banks that need it. The interest rate that the Federal Reserve charges its member banks is called the\u00a0discount rate<\/span><\/strong>. 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\u00a0spread,<\/em>\u00a0or 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.<\/p>\n\n\n\n\n\n\n\n\n\n\n\n
      The Federal Reserve System\u2019s Monetary Tools and Their Effects<\/th>\n<\/tr>\n
      Tool<\/th>\nAction<\/th>\nEffect on Money Supply<\/th>\nEffect on Interest Rates<\/th>\nEffect on Economic Activity<\/th>\n<\/tr>\n<\/thead>\n
      Open market operations<\/td>\nBuy government bonds<\/td>\nIncreases<\/td>\nLowers<\/td>\nStimulates<\/td>\n<\/tr>\n
      Sell government bonds<\/td>\nDecreases<\/td>\nRaises<\/td>\nSlows Down<\/td>\n<\/tr>\n
      Reserve requirements<\/td>\nRaise reserve requirements<\/td>\nDecreases<\/td>\nRaises<\/td>\nSlows Down<\/td>\n<\/tr>\n
      Lower reserve requirements<\/td>\nIncreases<\/td>\nLowers<\/td>\nStimulates<\/td>\n<\/tr>\n
      Discount rate<\/td>\nRaise discount rate<\/td>\nDecreases<\/td>\nRaises<\/td>\nSlows Down<\/td>\n<\/tr>\n
      Lower discount rate<\/td>\nIncreases<\/td>\nLowers<\/td>\nStimulates<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n