Question

Explain the two main functions of the Federal Reserve Bank, and name and describe the three main monetary policy tools that it has at its disposal.

Answer 1

two main functions of the Federal Reserve Bank;

1. Setting monetary policy

The Fed promotes a healthy U.S. economy through its monetary policy. The FOMC holds eight meetings per year to review economic trends and vote on new monetary policy measures.

Officially, there are two monetary policy goals that the Fed is striving to achieve:

1. High employment
2. Low inflation

The main way the Fed achieves these monetary policy goals is by setting a federal funds target rate. All depository institutions — meaning financial institutions that mainly receive funds through consumer deposits — need to hold a certain amount of money at Reserve Banks. If a bank or other depository institution doesn’t have enough in its reserves to meet their requirements, it can get an overnight loan from another financial institution. The rate of interest that an institution charges for such a loan is based on the federal funds target rate.

To fight inflation, the Fed can aim to raise the federal funds target rate. Alternatively, to fight off a recession, the Fed can aim to lower it.

While changes to the federal funds target rate don’t trigger changes in other interest rates automatically, it does directly impact them. This is because financial institutions generally watch and respond to the federal funds target rate in determining their own overnight lending rates, as described above. The prime rate— published by the Wall Street Journal and widely used as a benchmark for interest rates on everything from consumer credit cards to mortgage loans — is a reflection of those overnight lending rates.

This is how the Fed uses the federal funds target rate to help control interest rates over the long term and the amount of credit and money available in the market — factors that can eventually influence unemployment and inflation, the Fed’s two main concerns.

2. Supervising and regulating banks

The Fed supervises and regulates many banks and other financial institutions to promote stability in the financial markets.

The Board of Governors sets guidelines for banks through regulations, policy and supervision. A lot of these guidelines are created because of new legislation.

Each of the 12 Reserve Banks examines member banks to ensure they comply with laws and regulations. If a bank is state-chartered and not a member of the Federal Reserve System, the FDIC has supervisory authority.

three main monetary policy tools;

1. Open market Operations

Open market operations are when central banks buy or sell securities. These are bought from or sold to the country's private banks. When the central bank buys securities, it adds cash to the banks' reserves. That gives them more money to lend. When the central bank sells the securities, it places them on the banks' balance sheets and reduces its cash holdings. The bank now has less to lend. A central bank buys securities when it wants expansionary monetary policy. It sells them when it executes contractionary monetary policy.

Quantitative easing is open market operations on steroids. Before the recession, the U.S. Federal Reserve maintained between $700-$800 billion of Treasury notes on its balance sheet. It added or subtracted to affect policy, but kept it within that range. QE almost quintupled holdings of Treasury notes and mortgage-backed securities to more than $4 trillion by 2014.56

2. Reserve Requirement

The reserve requirement refers to the money banks must keep on hand overnight. They can either keep the reserve in their vaults or at the central bank. A low reserve requirement allows banks to lend more of their deposits. It's expansionary because it creates credit.

A high reserve requirement is contractionary. It gives banks less money to lend. It's especially hard for small banks since they don't have as much to lend in the first place. That's why most central banks don't impose a reserve requirement on small banks. Central banks rarely change the reserve requirement because it's difficult for member banks to modify their procedures.

Central banks are more likely to adjust the targeted lending rate than the reserve requirement. It achieves the same result with less disruption.

The fed funds rate is perhaps the most well-known of these tools. Here's how the fed funds rate works. If a bank can't meet the reserve requirement, it borrows from another bank that has excess cash. The interest rate it pays is the fed funds rate. The amount it borrows is called the fed funds. The Federal Open Market Committee sets a target for the fed funds rate at its meetings.

Central banks have several tools to make sure the rate meets that target. The Federal Reserve, the Bank of England, and the European Central Bank pay interest on the required reserves and any excess reserves. Banks won't lend fed funds for less than the rate they're receiving from the Fed for these reserves. Central banks also use open market operations to manage the fed funds rate.

3. Discount Rate

The discount rate is the third tool. It's the rate that central banks charge its members to borrow at its discount window. Since it's higher than the fed funds rate, banks only use this if they can't borrow funds from other banks.

Using the discount window also has a stigma attached. The financial community assumes that any bank that uses the discount window is in trouble. Only a desperate bank that's been rejected by others would use the discount window.