Question

How does the Federal Reserve implement its monetary policy; what tools are at its disposal, and how can those tools be utilized? Not less than 250 words and please include references.

Answer 1

The Federal Reserve’s (Fed) monetary policy refers to those actions taken by it that influences the amount of money as well as amount of credit in the U.S. economy. Monetary policy is very important as what happens to money and credit affects the cost of credit (through impact on interest rates) and this in turn affects the performance of the economy of USA.

To implement its monetary policies and achieve its monetary policy goals the Fed has three tools at its disposal – (i) discount rate (ii) reserve requirements (iii) open market operations.

Discount rate – This is the rate that Fed charges commercial banks for short term loans. Lending at discount rates by Fed complements open market operations and helps in achieving target federal funds rate. Lowering of discount rates has an expansionary impact as it directly influences other interest rates. It will lead to higher capital expenditures being planned by industries and higher consumer expenses by consumers. This will impact the economy in a positive way. Increasing the discount rates will have an opposite impact and economy will shrink.

Reserve requirements – These are the portion of deposits that a bank must hold in cash as a deposit with the Fed. Just like the discount rate a decrease in reserve requirements is expansionary in nature as increases the amounts of funds at the disposal of the banking system. This increased amount can be lent to business establishments as well as consumers. Similarly increase will lead to contraction of economy.

Open market operations – This involves buying and selling of U.S. government securities in the open market. These actions, in turn, influence the level of reserves in the banking system.

References:

1. Conduction monetary policy. Retrieved from https://www.federalreserve.gov/aboutthefed/files/pf_3.pdf

2. FRBSF – Retrieved from https://www.frbsf.org/education/teacher-resources/what-is-the-fed/monetary-policy/