Question

What are three different interest rates that the Fed uses as part of its monetary policy operations today?

Answer 1

Solution:

Monetary policy refers to any kind of policy which affects the money supply in an economy. There are three main factors through which Fed influences the money supply in the economy:

1. Open market operations: which involves sale and purchase of government securities in open financial market to the banks. When selling (purchasing) these securities, it receives (pays) money to the banks, which is like outflow (inflow) of money, resulting in decrease (increase) in the money supply. This operation affects the basic credit price or interest rates on loans (lending rates) in economy.

2. Discount rate: Discount rate is the rate Fed charges on lending they make to the commercial banks. With increase in such rates, it becomes more expensive for the banks to take loan from Fed, thereby reducing the desirable loans and hence, money supply in the economy.

3. Reserve requirements: Fed also sets the reserve requirement ratio (RRR), which tells the ratio or percentage of checkable deposits that commercial banks are required to maintain as reserves. If this ratio is increased, it means that banks will have to maintain higher ratio of deposits as reserves, and thus can loan out a lower proportion of deposits. With decrease in such loans, money in circulation, or the money supply decreases.