Question

List and explain the primary tools does the Fed have for conducting monetary policy.

Answer 1

The Fed can use four tools to achieve its monetary policy goals: the discount rate, reserve requirements, open market operations, and interest on reserves.

Discount Rate- The discount rate is the interest rate on short-term loans that Reserve Banks offer to commercial banks. Federal Reserve discount-rate lending complements open market operations in reaching the federal funds target rate and acts as a source of liquidity for commercial banks to back up. Lowering the discount rate is broad, since certain interest rates are affected by the discount rate. Lower rates promote business and company lending and spending. Likewise, increasing the discount rate is contractionary, since certain interest rates are affected by the discount rate. Higher rates discourage consumer and enterprise lending and spending.

Reserve requirements are the portions of deposits that banks are required to hold in cash, either in their vaults or on a reserve bank deposit. A decrease in reserve requirements is expansionary as it increases the funds available for lending to consumers and businesses within the banking system. An increase in reserve requirements is contractionary, as it reduces the funds available for lending to consumers and businesses in the banking system. The Governing Board has exclusive control over amendments to the criteria for reserves. The Fed never adjusts its reserve criteria

Open market operations, the acquisition and selling of U.S. government securities, is a effective tool. As we heard earlier, this resource is regulated by the FOMC and run by New York's Federal Reserve Bank.

Interest on Reserves is the newest and most frequently used instrument given by Congress to the Fed after the 2007-2009 financial crisis. Reserve interest is paid out on excess reserves held at Reserve Banks. Remember that Banks are mandated by the Fed to keep a percentage of their reserve deposits. In addition to these reserves banks also retain additional reserve funds. The new policy of paying interest on reserves enables the Fed to use interest to manipulate bank lending as a monetary policy weapon.