The United States Congress established three main aims for monetary policy in the Federal Reserve Act to help deal with inflation indirectly, acquire maximum employment, stabilize prices and regulate interest rates. This paper illustrates the use of the three keys namely Open Market Operations, Discount rates and federal reserves
Tools used by the Federal Reserves to Implement Monetary Policies
The three most important tools used are open market operations (OMO), setting discount rate and setting the reserve requirements. OMO is the most used tool of implementing monetary policies since the government cannot control inflation it thus buys and sells bonds to increase or decrease the money supply in circulation respectively. The decision to buy or sell the bonds influences the reserves in the banking sector. The purchase or sales of the securities mainly government-sponsored enterprises, the U.S. Treasury, and Federal agencies conducted by the Domestic Trading Desk of the Federal Reserve Bank of New York as directed by FOMC. Securities are bought and paid by the Fed by depositing to the primary account that the Fed maintains by the prime dealer's bank. On the other hand, in case the Fed wants to sell the securities, it takes money from the banks reserves. The two activities can be portrayed by the two equations namely expansionary and contractionary (Strawser, & Ryan, 2014).
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Expansionary: Fed buys bonds Money Supply MS increases Price of bonds increases interest rate decreases
Contractionary: Fed sells bonds Money Supply MS decreases Price of bonds decreases interest rate increases
The Discount Rate
A discount rate is the interest rate that Fed reserves charge banks to borrow in their reserves. Banks borrow from the fed when their reserves are lower than those required to meet the reserve requirement. The Fed sets and changes the discount rate and is usually used every couple of months or whenever necessary. The Fed in the need to increase money in circulation lowers the discount rate, thus encouraging the banks to borrow at lower interests and enable banks to offer loans at lower interest rates to the public (Camhi, 2015).
On the other hand, the Fed may opt to facilitate the discount rate with either creating their interest rate by enabling: seasonal credit, secondary credit or primary credit. Primary credit is mainly an overnight program. Thus, the banks use the program to backup funding as the interest is mainly set above the fed funds rate. The secondary program is used if the bank does not qualify to receive the primary credit and is more expensive than the major credit. Seasonal credit is suitable for small banks experiencing loans and deposits fluctuations. The changes are seasonal. Thus, the program is responsible for these kinds of banks that have bright recurring patterns of fluctuations, and the interest rates vary depending on the market rates. The discount rate affects the interest rate in the market (Camhi, 2015).
Reserve Requirements
This is the third tool used by the Fed and is basically as the name states. It is the minimum reserve-deposit ratio banks are required to have in their reserves. The reserves cannot be used for loans or any other investments as the banks have to have the reserves at all times. Being the oldest tool of monetary policy it rarely changes and commonly used in developing nations. The general perception is that if the reserve requirements are increased, banks will have less money to loan out or invest while the vice versa is correct that is the reduction of reserve requirements increases the money for banks to loan out and invest. It is rarely used since it is hard to predict the outcome over a short-run and may easily lead to bankruptcy (Strawser, & Ryan, 2012).
References
Camhi, B. (September 4, 2015). How The Federal Reserve’s Rate Hike Would Impact Local Government . Retrieved May 14, 2016, from, http://opengov.com/blog/how-the-federal-reserves-rate-hike-would-impact-local-government/
Strawser, C. J., & Ryan, M. M. (2012). Business statistics of the United States, 2012: Patterns of economic change . Lanham, Md: Bernan Press.
Strawser, C. J., & Ryan, M. M. (2014). Business statistics of the United States, 2013: Patterns of economic change . Lanham, Md: Bernan Press.
