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How The U.S. Government Formulates Monetary Policy

1/6/2013

How The U.S. Government Formulates Monetary Policy

December 31 2011| Filed Under » Banking, Economics, Laws and Regulation

A monetary policy is the means by which a central bank (also known as the "bank's bank" or the

"bank of last resort") influences the demand, supply and, hence, price of money and credit, in order

to direct a nation's economic objectives. Following the Federal Reserve

Reserve (the U.S. central bank) was given the authority to formulate U.S. monetary policy. To do this, the Federal Reserve uses three tools: open market operations, the discount rate and reserve requirements.

, the discount rate and reserve requirements . Act of 1913, the Federal Tutorial: Introduction To

Act of 1913, the Federal

Within the Federal Reserve, the Federal Open Market Committee (FOMC) is responsible for implementing open market operations, while the Board of Governors looks after the discount rate and reserve requirements.

looks after the discount rate and reserve requirements. The Federal Fund Rate The three instruments we

The Federal Fund Rate The three instruments we mentioned above are used together to determine the demand and supply of the money balances that depository institutions, such as commercial banks, hold at Federal Reserve

banks. The dollar amount placed with the Federal Reserve in turn changes the federal fund rate. This

is the interest rate at which banks and other depository institutions lend their Federal Bank deposits

to other depository institutions; banks will often borrow money from each other to cover their customers' demands from one day to the next. So, the federal fund rate is essentially the interest rate that one bank charges another for borrowing money overnight. The money loaned out has been deposited into the Federal Reserve based on the country's monetary policy.

Federal Reserve based on the country's monetary policy. 0 comments Leave a message DDiissccuussssiioonn The federal

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based on the country's monetary policy. 0 comments Leave a message DDiissccuussssiioonn The federal fund rate

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DDiissccuussssiioonn
DDiissccuussssiioonn
policy. 0 comments Leave a message DDiissccuussssiioonn The federal fund rate is what establishes other short-

The federal fund rate is what establishes other short- term and long-term interest rates and

foreign currency exchange rates. It also influences other economic phenomena, such as inflation. To

determine any adjustments that may be made to monetary policy and the federal fund rate, the FOMC meets eight times a year to review the nation's economic situation in relation to economic goals and the global financial situation. (To learn about the

relationship between inflation and bonds

Interest Rates, Inflation And The Bond Market .) read Open Market Operations Open market operations are
Interest Rates, Inflation And The Bond Market .) read Open Market Operations Open market operations are

read

Open Market Operations

Open market operations are essentially the buying and selling of government-issued securities (such as U.S. T-bills) by the Federal Reserve. It is the primary method by which monetary policy is formulated. The short-term purpose of these operations is to obtain a preferred amount of reserves

held by the central bank

a preferred amount of reserves held by the central bank and/or to alter the price of

and/or to alter the price of money through the federal fund rate.

When the Federal Reserve decides to buy T-bills from the market, its aim is to increase liquidity in the market, or the supply of money, which decreases the cost of borrowing, or the interest rate.

On the other hand, a decision to sell T-bills to the market is a signal that the interest rate will be

increased. This is because the action will take money out of the market (too much liquidity can result

in inflation), therefore increasing the demand for money and its cost of borrowing. (To learn more

The Discount Rate The discount rate is essentially the interest rate that banks and other depository institutions are charged to borrow from the Federal Reserve. Under the federal program, qualified depository institutions can receive credit under three different facilities: primary credit, secondary credit and seasonal credit. Each form of credit has its own interest rate, but the primary rate is generally referred to as the discount rate.

The primary rate is used for short-term loans, which are basically extended overnight to banking and depository facilities with a solid financial reputation. This rate is usually put above the short-term

reputation. This rate is usually put above the short-term Follow Us: Marketplace American Express – Savings
reputation. This rate is usually put above the short-term Follow Us: Marketplace American Express – Savings

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How The U.S. Government Formulates Monetary Policy

1/6/2013

market-rate levels. The secondary credit rate is slightly higher than the primary rate and is extended to facilities that have liquidity problems or severe financial crises. Finally, seasonal credit is for institutions that need extra support on a seasonal basis, such as a farmer's bank. Seasonal credit rates are established from an average of chosen market rates. (For more read Internal Rate of Return: An Inside Look.)

Reserve Requirements The reserve requirement is the amount of money that a depository institution is obligated to keep in Federal Reserve vaults, in order to cover its liabilities against customer deposits. The Board of Governors decides the ratio of reserves that must be held against liabilities that fall under reserve regulations. Thus, the actual dollar amount of reserves held in the vault depends on the amount of the depository institution's liabilities.

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Liabilities that must have reserves against them include net transactions accounts

Liabilities that must have reserves against them include net transactions accounts , non-personal 2

, non-personal

2
2

time deposits and euro-currency liabilities; however, as of Dec. 1990, the latter two have had reserve ratio requirements of zero (meaning no reserves have to be held for these types of accounts).

latter two have had reserve ratio requirements of zero (meaning no reserves have to be held

The Bottom Line By influencing the supply, demand and cost of money, the central bank's monetary policy affects the state of a country's economic affairs. By using any of its three methods - open market operations, discount rate or reserve requirements - the Federal Reserve becomes directly responsible for prevailing interest rates and other related economic situations that affect almost every financial aspect of our daily lives. (Want more information on how the Fed influences the economy? Read The Fed's New Tools For Manipulating The Economy.)

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How The U.S. Government Formulates Monetary Policy

1/6/2013

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