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How Monetary Policy Works

The Fed can use four tools to achieve its monetary policy goals: the discount rate, reserve requirements, open market operations and interest on reserves. All four affect the amount of funds in the banking system.

  • The discount rate is the interest rate Reserve Banks charge commercial banks for short-term loans. Federal Reserve lending serves as a backup source of liquidity for commercial banks. Lowering the discount rate is expansionary because the discount rate influences other interest rates, and, lower rates encourage lending and spending by consumers and businesses. Likewise, raising the discount rate is contractionary because the discount rate influences other interest rates, and, higher rates discourage lending and spending by consumers and businesses.
  • Reserve requirements are the portions of deposits that Banks must hold in cash, either in their vaults or on deposit at a Reserve Bank. Decreasing the reserve requirement is expansionary because it increases the funds available in the banking system to lend to consumers and businesses. Increasing the reserve requirement is contractionary because it reduces the funds available in the banking system to lend to consumers and businesses. The Fed rarely changes the reserve requirement.
  • Open market operations, the buying and selling of U.S. government securities, has been a reliable tool. As we learned earlier, this tool is directed by the FOMC and carried out by the Federal Reserve Bank of New York.
  • Interest on reserves is the newest and most frequently used tool given to the Fed by Congress after the Financial Crisis of 2007-2009. Interest on reserves is paid on excess reserves held at Reserve Banks. Remember that the Fed requires banks to hold a percentage of their deposits on reserve. In addition to these reserves banks often hold extra funds on reserve. The current policy of paying interest on reserves allows the Fed to use interest as a monetary policy tool to influence bank lending. For example, if the FOMC wanted to create a greater incentive for banks to lend their excess reserves, it could lower the interest rate it pays on excess reserves. Banks are more likely to lend money rather than hold it in reserve (so they can make more money) creating expansionary policy. In turn, if the FOMC wanted to create an incentive for banks to hold more excess reserves and decrease lending, the FOMC could increase the interest rate paid on reserves, which is contractionary policy.

Gathering Data

Research economists at all 12 Reserve Banks, as well as at the Board of Governors, contribute to the policymaking process. Members of the research staff gather, analyze, evaluate and share information about the economy. Before each FOMC meeting, for example, researchers survey key industry contacts within their districts and assemble a report called the Beige Book, which can often highlight meaningful trends in economic activity before they show up in national statistics. The Beige Book serves as an up-to-the-minute resource for FOMC discussions and its contents are widely reported in the press.

To read the current Beige Book report click here.

The loans and deposit data that Reserve Banks collect from depository institutions are some of the most critical statistics the Fed gathers. Such information is used in analyzing regional and national bank performance, credit demand and other banking concerns.

Now that you know more about the FOMC and monetary policy, let's see if you would make the same choices for members of the Board of Governors.


Discussion Board Topic: Choosing the Board of Governors

Use what you have learned in this lesson to write a summary paragraph. Your paragraph should explain:

  • How were the criteria for choosing a regional board member different than those criteria for choosing a member of the Board of Governors?
  • Did your choices for members of the Board of Governors change? If so, explain why.

Record your summary by clicking on the discussion board and responding to the thread titled "Choosing the Board of Governors."