ECON102: Principles of Macroeconomics (2021.A.01)

Monetary Policy

The Federal Reserve

What is monetary policy?

The term monetary policy refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit as a means of helping to promote national economic goals.

How does the Federal Reserve implement monetary policy?

The Federal Reserve implements monetary policy using three major tools:

• Open market operations. The buying and selling of U.S. Treasury and federal agency securities in the open market
• Discount window lending. Lending to depository institutions directly from their Federal Reserve Bank’s lending facility (the discount window), at rates set by the Reserve Banks and approved by the Board of Governors
• Reserve requirements. Requirements regarding the amount of funds that depository institutions must hold in reserve against deposits made by their customers.
  

Using these tools, the Federal Reserve influences the demand for and supply of balances that depository institutions hold on deposit at Federal Reserve Banks (the key component of reserves) and thus the federal funds rate--the interest rate charged by one depository institution on an overnight sale of balances at the Federal Reserve to another depository institution. Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit in the economy, and, ultimately, a range of economic variables, including employment, output, and the prices of goods and services.

What is the federal funds rate, and why does the FOMC raise or lower the target rate?

The federal funds rate is the rate charged by one depository institution on an overnight sale of immediately available funds (balances at the Federal Reserve) to another depository institution; the rate may vary from depository institution to depository institution and from day to day. The target federal funds rate is set by the Federal Open Market Committee (FOMC). By setting a target federal funds rate and using the tools of monetary policy--open market operations, discount window lending, and reserve requirements--to achieve that target rate, the Federal Reserve and the FOMC seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," as required by the Federal Reserve Act.

At each of its meeting, the FOMC examines a number of indicators of current and prospective economic developments. Then, cognizant that its actions affect economic activity with a lag, it must decide whether to alter its target for the federal funds rate. An actual decline in the rate stimulates economic growth, but an excessively high level of economic activity can cause inflation pressures to build to a point that ultimately undermines the sustainability of an economic expansion. An actual rise in the rate curbs economic growth and helps contain inflation pressures, and thus can promote the sustainability of an economic expansion; too great a rise, however, can retard economic growth too much. The FOMC's actions on the target federal funds rate are undertaken to achieve the maximum rate of economic growth consistent with price stability and moderate long-term interest rates.

For more information on the federal funds rate, see Federal funds data on the Federal Reserve Bank of New York's website.

What are the historical changes in the target federal funds rate?

The Federal Reserve's objective in using the tools of monetary policy may be a desired quantity of reserves or a desired price of reserves--the federal funds rate. During the 1980s, the approach gradually changed from seeking a desired quantity of reserves toward attaining a specified level of the federal funds rate, a process that was largely complete by the end of the decade. In 1995, the FOMC began announcing its target level for the federal funds rate.

What is the money stock, and how does the Federal Reserve influence it?

Generally, the money stock consists of currency held by the public; transaction, savings, and time deposits held by the public at depository institutions; the assets of money market mutual funds; and certain other depository institution liabilities. The Federal Reserve affects the money stock chiefly by its influence over interest rates. When the Federal Open Market Committee lowers the target federal funds rate, the rate at which depository institutions purchase and sell overnight funds to one another in the market falls, and so do other short-term interest rates. Lower short-term market interest rates increase the attractiveness of the rates paid on deposits at commercial banks and other depository institutions because changes in these rates tend to lag changes in market rates. Consequently, the public tends to purchase the assets included in the money stock, and money growth increases. Conversely, when the FOMC raises the target federal funds rate, the federal funds rate increases, as do other short-term interest rates. The rates paid on assets included in the money stock become less attractive, and money growth slows.

What is the discount rate?

The discount rate is the interest rate that an eligible depository institution is charged to borrow funds, typically for a short period, directly from a Federal Reserve Bank. By law, the board of directors of each Reserve Bank sets the discount rate independently every fourteen days subject to the approval of the Board of Governors. Originally, each Reserve Bank set its discount rate to reflect the banking and credit conditions in its own District. Over the years, the transition from regional credit markets to a national credit market has gradually produced a national discount rate. As a result, the Federal Reserve maintains a uniform structure of discount rates across all Reserve Banks.

For more information on the discount rate, see The Federal Reserve System: Purposes and Functions.

How does the Federal Reserve maintain the stability of the financial system?

The Federal Reserve's roles in conducting monetary policy, supervising banks, and providing payment services to depository institutions help it maintain the stability of the financial system.

Using the monetary policy tools at its disposal, the Federal Reserve can promote an environment of price stability and reasonably damped fluctuations in overall economic activity that helps foster the health and stability of financial institutions and markets. The Federal Reserve also helps foster financial stability through the supervision and regulation of several types of banking organizations to ensure their safety and soundness. In addition, the Federal Reserve operates certain key payment mechanisms and oversees the operation of the payment system more generally, with the goal of strengthening and stabilizing the system.

The Federal Reserve engages in all these activities on a routine basis, but the stabilization activities of a central bank are especially evident and critical during periods of financial stress, such as those that occurred following the stock market decline of October 1987, the international debt crisis in the fall of 1998, and the terrorist attacks in September 2001. In these instances, the Federal Reserve promoted financial system stability by providing ample liquidity (balances at the Federal Reserve) through large open market purchases of securities (using short-term repurchase agreements) and by extending discount window loans to depository institutions.

Where can I obtain copies of the Federal Reserve's Monetary Policy Reports to Congress?

The Federal Reserve Board's semiannual Monetary Policy Reports to Congress are available online. You may also order paper copies of the report.

Does the Federal Reserve control or set the prime rate?

No, banks set their own rates based on the demand for various kinds of loans, the cost of money to the banks, and the administrative costs of making loans.

This work is in the Public Domain.