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monetary policy One of the functions that the United States Congress charged the Federal Reserve System with in 1913 was guiding monetary policy.  Now, it is certainly the Fed's most famous responsibility.  Yet few people really understand how it is that the Fed guides the nation's economy.  And there's good reason for that — it's complicated!

The overall economic goals of the Federal Reserve are maximum employment, stable prices, and moderate long-term interest rates.  When reached, those goals indicate that the U.S. economy is strong and stable.

There are a number of factors that affect employment, prices, and interest rates — and the Federal Reserve has no control over most of those factors.  What the Federal Reserve does have some control over is the nation's money supply.  And the Fed has three possible tools to control — to some extent — the amount of money in the economy.

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The Discount Rate

One of those tools is the discount rate, the interest rate Federal Reserve Banks charge their member banks for short-term loans.  If the Fed lowers the discount rate, for example, it becomes more lucrative than before for banks to borrow money from the Fed — so they do borrow, putting money into circulation in the economy.  If, on the other hand, the Fed wants to decrease the amount of money in the economy, it can raise the discount rate, making it less lucrative for banks to borrow money from the Fed, so they borrow less, leaving more cash on deposit at the Fed and less in circulation in the economy.

The Board of Governors and regional Federal Reserve Banks together have the ability to change the discount rate — which they do — though it is not the Fed's preferred tool for effecting economic change.

Open Market Operations

The Fed's preferred tool for effecting economic change is open market operations, the buying and selling of U.S. government securities on the open market.  Open market operations are conducted at the Federal Reserve Bank of New York; their purpose is to affect the federal funds rate, the rate at which banks lend each other money from their Federal Reserve Bank balances.

Even though banks are lending money from their Federal Reserve deposit accounts, the Fed cannot actually change the federal funds rate.  Instead, the Federal Open Market Committee targets a federal funds rate that it believes would mean stability and strength for the economy on the whole.  Then it engages in open market operations to try and get the actual federal funds rate close to the target rate.

Open market operations are based on the same principle as the discount rate:  changing the supply of money.  By selling government securities, for example, the Federal Reserve decreases the supply of money available to depository institutions (because it's effectively giving security notes in exchange for cash) — and that, in turn, increases the price of that money — the federal funds rate.  Buying government securities, on the other hand, increases the supply of money available to depository institutions (it's effectively taking security notes in exchange for cash), which, in turn, decreases the price of that money — the federal funds rate.

As if that wasn't complicated enough, the actual federal funds rate is affected not only by the supply of money in the economy, but also by perceptions of the economy's future.  Because open market operations are an indirect way of getting the market to adjust the federal funds rate, there are no guarantees that the market will actually do what the Fed wants.  If banks think that the fed funds rate will be lower tomorrow than it is today, they may wait until tomorrow to borrow money in the fed funds market — no matter what the Fed does.

So it's critical that the Fed be ever-vigilant about the effect of its statements and actions on perceptions.  Prior to July, 1995, for example, the Fed did not announce its target federal funds rate.  Since then, perhaps more in the spirit of "full disclosure", the Fed has announced its target rate.  Certainly, concerns about how the Fed's behaviors affect market perceptions keeps many a Fed governor awake at night.

The Reserve Requirement

The third tool in the Fed's monetary policy arsenal is the reserve requirement, the portion of a member bank's deposits that it must hold in reserve in its own vaults or on deposit at its regional Reserve bank.  The Fed rarely uses the reserve requirement as a monetary policy tool.
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Federal Reserve Bank - Monetary Policy