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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21 Responses to Finance for Dummies – Federal Reserve Monetary Policy

  1. Shaun @ Money Cactus 11/25/2011 at 6:06 am #

    Even though I don’t live in the states, it is great to learn more about the monetary policy. The US dollar has such a big impact around the world as an international measure. Loving the dummies series by the way!

  2. John 11/24/2011 at 3:45 pm #

    The problem at the Fed, the Bank of England, the European Central Bank etc etc is that as interest rates are now on the floor and have been for quite a long time, that becomes a very blunt weapon in controlling the domestic inflation, demand or whatever. You can’t go much lower yet a move up of 25 basis points (1/4%) is actually quite a lot. And while the capital reserve ratio has over recent years been very low, coupled with the low interest rates, we have seen an explosion in demand that the clearing banks have been only too happy to service with their generated money. If the velocity of circulation is sufficiently high (ie quick turnover of debt) the capital requirements are not particularly effective either.

    Just a thought for you over there on Thanksgiving …. 🙂

    • Paul 11/24/2011 at 8:58 pm #

      A little over a year ago, global banking regulators adopted new banking regulations (Basel III) that would require banks to increase capital reserves in order to withstand a 30-day bank run. Currently U.S. banks are short of required capital to the tune of $1.4 Trillion Dollars. Banks executives have complained to regulators and are asking for the reserve limits to be lowered before the 2018 deadline.
      European Banks treat sovereign debt as having zero risk, unlike American Banks which are required to hold 5% capital reserve as stipulated by Basel II. European Banks hold $3 Trillion of sovereign debt which has put the entire European banking system at risk and could result in several countries defaulting. Another real worry is that Greece, Italy, or Spain pulling out of the EU and causing investors to flee the euro for the dollar. That would be disastrous for the global economy.

      • John 11/25/2011 at 3:08 am #

        @Paul – I hadn’t realised the difference between American and European attitudes to sovereign debt so thanks for that. I have always wondered why states are treated any differently and it seems you have it right. The Web of Debt is interesting and shows the connections (except for China where there is no reliable data).

        It does seem to me that investors are running round like headless chickens not knowing what to do next. Clearly we have to wait for agreement in the Eurozone on the role of the ECB and also stability in the PIIGS governments. And the ratings agencies – who have not covered themselves with glory in recent years – downgrade which makes it even more inevitable that something disastrous will happen.

        As far as the Euro is concerned (and I think you are confusing the Euro with the EU here) the toxicity is affecting the market attitude to Germany which is now paying more than the UK in interest/yield.

        • Paul 11/25/2011 at 4:49 pm #

          Hi John,
          Thanks for sharing your insight into the current economic situation in Europe, very interesting. I was reading an article in The Wall Street Journal about investors fleeing the euro for short-term 1 year or less German bunds. German debt is slightly more attractive than U.S. Treasuries but that may change when the European Central Bank lowers the current 1.25% benchmark rate to below 1%.

          • John 11/25/2011 at 5:19 pm #

            HI Paul.

            Yes there is a certain malaise over here. The Eurozone initially considered the issue to be Anglo American, even though they have as you pointed out been rather careless in the requirements for the banks vis-a-vis sovereign debt. On the backs of this and the presumed unassailable Germain economy, the ECB raised interest rates whereas they should have kept them on the floor and lived with a bit of inflation for a while. Now we have the situation where Germany wont allow the ECB to do what every other central bank has been doing – and Merkel is really calling the shots.

            Ever since Oscar La Fontaine (German finance minister for a short while) pronounced I think in about 1998 that a common currency would need fiscal ‘co-ordination’, I have regarded the Euro as a political answer to a banking problem – that of harmonising prices across the zone. This is a good idea in theory – being able to travel around without changing money all the time. But AFAIK never in history has there been a financial union without it being preceeded by political union. You can think Roman Cirsterces or the US dollar . The first didn’t really occur until 1st Century AD and the second was fairly soon after tea time in 1776 (there were a few states that retained their own dollar for a few years and there was some disconnection during the Civil War).

            I just hope that the Euro problems won’t bring us all down. As a currency it had pretensions of challenging the USD but I think a greater challenge will come once China decouples the Yuan.

            While we are ‘out of it’ in the UK – and very unlilkely ever to join – any failure or run on the Euro will damage us severely because we have a lot of trade and business in the Eurozone and London is of course by far the biggest financial market in Europe. So we are hoping and praying.

            More of this in a few weeks on the MoneyPrinciple blog….

          • Paul 11/25/2011 at 9:56 pm #

            You’ll have to let me know when you publish John!

  3. PKamp3 11/23/2011 at 10:09 pm #

    Will you expand this to Operation Twist? The triple mandate? Bengenie?

    Haha, good stuff.

    Also, Happy Thanksgiving!

  4. YFS 11/23/2011 at 8:52 pm #

    Good write up.. the main thing people need to focus on is “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.” I believe this has a bearing on what interest you will receive on your loans.

    • Paul 11/23/2011 at 9:46 pm #

      You are correct that the discount rate affects the cost of credit for consumers. As you know, credit rating and other factors determines the rate a particular consumer will pay. Thanks for stopping by YFS and have a nice Thanksgiving!

  5. JP @ Novel Investor 11/23/2011 at 7:19 pm #

    Got to say I like this series. I’ve been paying attention to the Fed minutes for several years now. It offers up a much better glimpse of the economy, what to look out for, what the Fed is doing about it and were it’s headed. Much more so, than listening to the opinion pundits.

    • Paul 11/23/2011 at 9:40 pm #

      Glad you like the series JP! The Fed has influence over just about every aspect of our financial lives so it is important to understand what the Fed’s policy is and be able to react when there is a change in policy.

  6. krantcents 11/23/2011 at 4:17 pm #

    Many people feel that the Fed should not tamper with the open market, but I think it balances some of the volatility.

  7. Miss T @ Prairie Eco-Thrifter 11/23/2011 at 8:45 am #

    Yay! Another dummies post. These are so great. It is always interesting to see how everything is connected and even things like the federal reserve can have a direct impact on our lives. Just goes to show we need to pay attention to more than we think.

    • Paul 11/23/2011 at 2:40 pm #

      Glad to find this series helpful Miss T!


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