There are three tools in which dictate monetary policy used by the Federal Reserve System in the United States: Open Market Operations, Discount Loans, and Changes in Reserve Requirements. Now, before I go further, I’ll briefly outline the definition of monetary policy itself, in which it is that of “The management of money and interest rates”. It’s as simply put as that. This will make things easier as far as trying to explain the rest of this particular summary.
The Fed can conduct monetary policy in three ways, as stated above, and these are briefly synopsized as such: By changing the money base in open market operations, changing it through discount loans, and by changing the money multiplier by changing the required reserve ratio.
First off, we will overview the first tool known as Open Market Operations. There are two types of Open Market Operations, including Open Market Purchases and Open Market Sales. The first, “Purchases” is where the Fed buys U.S. government securities to increase the monetary base, and the latter, “Sales”, is the opposite. Open Market Sales is when the Fed sells U.S. government securities to decrease the monetary base. Therefore, the Fed controls open market operations by buying and selling securities. Open market purchases and sales have everlasting affects on the monetary base. That is unless the Federal Reserve wants to change the monetary base on a temporary status. When the Fed wants a temporary change, it takes on two types of other transactions. These actions include the repurchase agreement and the matched-sale purchase transaction. As far as Open Market operations go, they are under complete control of the Federal Reserve, they can be large or small, and they can be reversed rather easily, and can be executed in a rather quick, advantages gesture.
The second tool used in the monetary policy, Discount Loans, is when a bank receives a discounted loan from the Federal Reserve. The Fed can also control the discount rate on these loans by making them higher or lower. The higher the loan the less desirable it is to borrow from a bank’s perspective. The lower the loan’s rate, the more attractive it is. Just as with individual people borrowing money, the same is true when it comes with banks in that discount lending is more important during a financial crisis. Discount loans are good in that they serve as a last resort when it comes to borrowing, especially during an economic panic. However, the Fed can make changes in the rates of the loans at any time, and when so, it takes a long time for it to be approved by the board.
The third and final tool used by the Federal Reserve to dictate monetary policy would be the Changes made in Reserve Requirements. Changes in the required reserve ratio can affect the money supply. However, there are many disadvantages to changing the required reserves. Bigger changes in reserves must be approved by the United States Congress, making it difficult to make these large changes right away or as soon as desired. Also, if a bank holds only a small amount of excess reserves and the required reserve ratio is increased, the bank will be forced to acquire reserves by borrowing or selling securities, or even reduce its loans to its customers.
After reviewing the three tools used by the Fed, it is easy to see that Open Market Operations are the most effective of the three in dictating monetary policy. An interesting note to share is that political Liberals favor low interest rates which make money cheaper and which enable low-income families to purchase things such as homes which offer the first significant step toward economic success. The other ended Conservatives, however, view monetary policy as a necessary part of capital creation, but commonly favor intervention as a way to keep the economy firm.