Question

How does the Fed currently conduct U.S. monetary policy? Your answer should involve all aspects of policy from tools to goals. Why does the Fed conduct policy as it currently does? For example, why does the Fed choose a particular tool? What are the limits of the Fed's ability to influence the economy?

Answer 1

To achieve its monetary policy goals, the Fed can use four tools: discount rate, reserve requirements, open market operations, and reserve interest. These four are influencing the amount of money in the banking system.

The discount rate for short-term loans is the interest rate charged by Reserve Banks to commercial banks. Lending at the discount rate by the Federal Reserve complements open market operations in achieving the federal funds target rate and acts as a source of liquidity relief for commercial banks. Reducing the discount rate is expansive because other interest rates are affected by the discount rate. Lower rates enable consumers and businesses to borrow and invest. Increasing the discount rate is also contractionary because other interest rates are affected by the discount rate. Higher rates discourage consumers and businesses from lending and spending.

Reserve requirements are portions of deposits that banks are required to keep in cash, either in their vaults or in reserve bank deposits. A reduction in reserve requirements is increasing as it increases the funds available for lending to consumers and businesses in the banking system. An increase in reserve requirements is contractionary, as it reduces the funds available for lending to consumers and businesses in the banking system. The Board of Governors has sole authority to change the requirements of the reserve. Reserve requirements are rarely changed by the Fed.

Open market operations, buying and selling securities from the U.S. government, were a reliable tool. As we learned earlier, this tool is managed by the FOMC and implemented by New York's Federal Reserve Bank.

Reserve interest is the newest and most frequently used tool given by Congress to the Fed following the 2007-2009 financial crisis. Excess reserves held at Reserve Banks pay interest on reserves. Recall that banks are required by the Fed to hold a percentage of their reserve deposits. Banks often hold additional funds on reserve in addition to these reserves. The current policy of paying interest on reserves allows the Fed to use interest to influence bank lending as a monetary policy tool. For example, if the FOMC wanted to create a greater incentive for banks to lend their excess reserves, the interest rate on excess reserves could be lowered. Banks are more likely to lend money instead of holding it in reserve (so they can make more money) to create expansionary policies. In addition, if the FOMC wanted to create an incentive for banks to hold more excess reserves and lower borrowing, the FOMC might raise the interest rate charged on reserves, which is the policy of contraction.