Monetary Policy Explained

A crash course on the Federal Reserve and what it does

What is monetary policy?

Monetary policy controls the overall availability and cost of credit in the U.S. economy. Monetary policy is shaped by the Federal Reserve, the central bank of the United States.

What are the main objectives of monetary policy?

The Federal Reserve’s three objectives include promoting maximum employment, maintaining stable prices, and moderating long-term interest rates through monetary policy, all key factors which ensure stable and prosperous economic conditions.

How does the Fed meet these goals?

The Fed accomplishes its economic goals by adjusting short-term interest rates. Though there are multiple types of interest rates with specific objectives, interest rates as a whole work to control the amount of money and credit available in the economy. These changes are implemented through distinct “tools.” Though a wide variety of innovative tools have been created to combat financial crises, the most commonly utilized tool involves controlling borrowing and lending habits between banks. In order to understand how the tools of the Fed work, a basic understanding of noncash payments must first be established.

How do noncash payments work?

The Fed estimates that each day, businesses and consumers combined make half a trillion dollars’ worth of noncash payments. These are payments made through debit cards, credit cards, checks, and electronic transfers. All banks hold a certain amount of reserve balances which are borrowed and lent to each other depending on their needs and market conditions in order to facilitate these noncash payments.

What are the most important tools of the Fed?

  • The Reserve Requirement

The Reserve Requirement is the amount of deposits banks must keep on hand each night, ensuring that they have a base level of funds to meet most consumer demands.

  • The Federal Funds Rate

The Federal Funds Rate is the interest banks pay to each other to borrow money when they do not have enough on hand. Raising or lowering the federal funds rate influences how willing banks are to borrow and lend from each other, which then determines how much credit is available in the market.

  • Open Market Operations (OMOs)

Open Market Operations are the actions used to reach federal funds rate targets, which manage conditions of this federal funds market. This is done through buying and selling government securities issued by the U.S. Treasury and other government agencies. Buying government securities removes capital from the open market, while selling them adds to the capital available to the public.

  • The Discount Rate

The Discount Rate is the interest banks must pay to borrow from the Federal Reserve’s discount window. This interest rate is usually set one point higher than the federal funds rate to discourage excessive borrowing from the Fed.

What types of monetary policy exist?

The Fed uses two general types of monetary policy to regulate the money supply in the economy. Contractionary policies reduce money supply with higher interest rates, while expansionary policies increase the money supply with lower interest rates. These general goals are chosen depending on current market conditions and long-term goals.

How does the Fed function?

The Federal Reserve System is comprised of three key entities: The Board of Governors, the Federal Reserve Banks, and the Federal Open Market Committee (FOMC). The Board of Governors is an agency of the federal government whose members are appointed by the President. These seven members report to Congress, oversee operations of the 12 Reserve Banks, and guide the operations of the Federal Reserve System. All members of the Board also serve on the FOMC, which is also comprised of the Presidents of all Reserve Banks. The FOMC is the body that sets all national monetary policy. It meets eight times per year. Lastly, the 12 Federal Reserve Banks serve as the “operating arms” of the Federal Reserve System, each functioning within a geographic district specific to the needs of local communities.

What’s the Difference Between Monetary and Fiscal Policy?

Though both monetary and fiscal policy seek to maximize the economy’s performance, they each have distinct qualities which impact how they function. Monetary policy is controlled by the Federal Reserve, which was established to broadly represent the public interest. Crucial to the Fed’s function is its independent decision-making process, which is free from the influence of federal government. In contrast, fiscal policy is determined by Congress and the Administration and is primarily carried out through tax and spending policies.

News coverage of the Fed’s latest monetary policy actions may sound confusing or complex, however understanding just a few of these terms and tools clarifies the objectives of monetary policy. Constructing a more solid conception of what the Fed is, how it works, and its primary goals enables citizens to better understand the importance of monetary policy changes which impact us on the individual level, as well as shape the large-scale trends which guide the U.S. economy.

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References:

www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm

www.federalreserve.gov/aboutthefed/files/pf_3.pdf

www.federalreserve.gov/faqs/money_12855.htm

www.federalreserve.gov/aboutthefed/files/pf_2.pdf

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