Finance for Dummies – Federal Reserve Monetary Policy

Finance for Dummies is a series about personal finance topics for those without a PhD in Finance!

What is Monetary Policy?

Monetary Policy is what the Federal Reserve does to influence the amount of credit and money available in the U.S. economy.  By influencing money and credit, the Federal Reserve is able to  interest rates and performance of the U.S. economy.

What is the Goal of Monetary Policy?

The goal of Monetary Policy is to moderate long-term interest rates, stabilize prices, and promote maximum employment.

How does the Federal Reserve Carry Out Monetary Policy?

The three main tools the Federal Reserve uses to implement Monetary Policy are the discount rate, capital reserve requirements, and open market operations.

The discount rate is the rate the Federal Reserve charges banks on short-term loans.

Open Market Operations involve the buying and selling of government securities such as treasury bills, notes, and bonds. The term “open market” means that the Federal Reserve buys and sells government securities openly to various securities dealers who compete on the basis of price.

Capital Reserve Requirements are the portion of deposits that banks are required to keep on hand or on deposit at a Federal Reserve Bank.

How do Open Market Operations Work?

Open Market Operations are the Federal Reserve's primary tool to influence the supply of money.  Under the direction of the FOMC, the Domestic Trading Desk of the Federal Reserve Bank of New York carries out the buying and selling of securities that are issued by the U.S. Treasury.

To increase the money supply, the Federal Reserve Bank of New York buys securities and pays for them by making a deposit to the account maintained by the Fed by the primary securities dealer's bank.  To decrease the supply of money, the Fed sells securities and withdraws funds from those accounts.  By trading securities, the Fed influences bank reserves, which in turn affects the federal funds rate, or the overnight lending rate banks are charged to borrow reserves from each other.

What is the FOMC?

The FOMC or Federal Open Market Committee, is responsible for setting the nations monetary policy.  The FOMC consists of 7 members of the Board of Governors, the President of the Federal Reserve Bank of New York and the presidents of four other Reserve Banks.  The FOMC meets 8 times per year and discusses the outlook for the U.S. economy and monetary policy options.

How is the FOMC's Policy Carried Out?

After each FOMC meeting, a statement is issued that includes the federal funds target rate and an explanation of the decision.  The committee then issues instructions to the New York Fed's Domestic Trading Desk to buy or sell securities through open market operations.   Open Market Operations are carried out on a daily basis to keep the federal funds rate from being influenced by technical market forces.

Why should I care about Federal Reserve Monetary Policy?

The Federal Reserve controls the supply of money which in turn influences the federal funds rate.  The Federal Reserve also sets the interest rate charged to banks for short-term loans.  The discount rate affects the interest rate consumers pay for credit such as home and auto loans.


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