BUS101: Introduction to Business

Monetary policy refers to the actions taken by the Federal Reserve to influence the availability and cost of money and credit to help promote the nation's economic goal of non-inflationary growth. The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy.

The Federal Open Market Committee (FOMC), the 12-member group, that formulates monetary policy for the Federal Reserve System, meets in Washington, D.C., usually eight times a year. At these meetings, the Committee reviews economic and financial conditions to determine the appropriate stance of monetary policy and assess the risks to its long-run goals of price stability and sustainable economic growth.

The Federal Reserve influences the economy through the market for balances that depository institutions maintain in their accounts at Federal Reserve banks. Banks keep reserves at Federal Reserve banks to meet reserve requirements and to clear financial transactions.

Transactions in the federal funds market allow depository institutions with reserve balances in excess of reserve requirements to sell reserves to institutions with reserve deficiencies at an interest rate known as the fed funds rate. The FOMC sets the target for the fed funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives and adjusts that target in line with evolving economic developments.

The Fed uses three tools to implement monetary policy, the most important being open market operations. These "domestic operations" are conducted for the System only by the New York Fed under the direction of the FOMC. Through open market operations, the Fed buys or sells U.S. Treasury securities in the secondary market to produce a desired level of bank reserves. These securities are held in the System's portfolio, which is known as the System Open Market Account or "SOMA".

The "primary dealers", designated by the New York Fed, serve as its counterparties in open market operations and other securities transactions. The Fed adds extra credit to the banking system when it buys Treasury securities from the dealers and drains credit when it sells to the dealers. As the laws of supply and demand take over in the reserves market, the cost of funds for the remaining reserves finds its level at the federal funds rate.

Discount window operations, a second monetary policy tool of the Fed, provide secured short-term loans to depository institutions temporarily in need of funds. Each of the 12 Reserve Banks lends to depository institutions in its district. Under the administration of the discount window revised January 9, 2003, an eligible institution need not exhaust other sources of funds before coming to the discount window, nor are there restrictions on the purposes for which the borrower can use primary credit. Banks borrow from the "window" at the discount rate that is set by each Reserve Bank but requires the approval of the Board of Governors. The rate is adjusted occasionally to reflect changes in market conditions and monetary policy objectives.

Reserve requirements establish the proportions of demand deposit (checking) accounts and time deposits that must be held as non-interest bearing reserves at Federal Reserve Banks or as vault cash. Reserve ratios are rarely changed, and any major adjustment would be viewed as a very significant monetary policy action. An increase in reserve requirements would be regarded as an attempt to restrict bank credit and restrain economic activity. A reduction in the reserve ratio would be viewed as a stimulative monetary policy move.

Open market operations of the Federal Reserve, borrowing at the discount window and from other sources, and reserve requirements together determine the total volume of reserves available to depository institutions. These reserves affect the ability of the banking system to "create" new money by establishing an upper limit on the quantity of deposits that banks can support. This effectively sets a maximum to the amount of money that banks can lend and invest. By influencing the supply of money and, in turn, the cost and availability of credit, the Fed's actions affect economic activity and prices.

For an overview of new policy tools that the Federal Reserve has implemented to address the financial crisis that emerged during the summer of 2007, go to Credit and Liquidity Programs and the Balance Sheet feature at the Board of Governors website.