Monetary Policy Videos | Education | St. Louis Fed

This segment explains how the Fed moves the economy toward maximum employment and price stability by setting a target range for the federal funds rate, and how ... Home> ResourcesForTeachers&StudentsinEconomicsandPersonalFinance> EconomicLowdownVideoSeries> ForTeachersandStudents ForTeachers&Students EconLowdownTeacherPortal FindTeacherResources Events TeacherPD Subscribe AboutUs Glossary ScopeandSequence PermittedUse MonetaryPolicy-TheEconomicLowdownVideoSeries TheFederalReserve,“theFed,”isthecentralbankoftheUnitedStates.OneofitsimportantfunctionsistopromoteastrongU.S.economy.Infact,CongresshasgiventheFedtwomaingoals:maximumemploymentandpricestability.ThesevideosexplainhowtheFedusesmonetarypolicytoreachthosegoals. Toprovidestudentswithonlinequestionsfollowingeachvideo,registeryourclassthroughtheEconLowdownTeacherPortal. LearnmoreabouttheVideoQ&AResourcesforTeachersandStudents» MonetaryPolicy,part1:TheFedandtheDualMandate ThissegmentexplainshowtheFedadjuststhetargetrangeforthefederalfundsratetosetoffachainofeventsintheeconomy.ThischainofeventseventuallyinfluencesthedecisionsofconsumersandbusinessesandmovestheeconomytowardtheFed’sdualmandategoalsofpricestabilityandmaximumemployment. PreviewtheVideoQ&AforPart1:TheFedandtheDualMandate MonetaryPolicy,part2:TwoImportantInterestRatesinMonetaryPolicyImplementation ThissegmentexplainshowtheFedusestwoimportantinterestrates—thefederalfundsrateandtheinterestonreservebalancesrate—toimplementmonetarypolicy.Whenbankslendfundstootherbanksfromtheseaccounts,theyearnthefederalfundsrate.WhenbanksholdfundsinreservebalanceaccountsattheFed,theyearntheinterestonreservebalancesrate.Butinterestonreservebalancesisn’tjustaboutinteresttransactions;theFedusestheinterestonreservebalancesratetosteerthefederalfundsrate. PreviewtheVideoQ&AforPart2:TwoImportantInterestRatesinMonetaryPolicyImplementation MonetaryPolicy,part3:ReservationRateandArbitrage Thissegmentexplainsthattheinterestonreservebalancesrateactsasareservationrateforbanks,andexplainshowarbitrageensuresthatitisaneffectivetoolforsteeringthefederalfundsrateintotheFOMC’starget. PreviewtheVideoQ&AforPart3:ReservationRateandArbitrage MonetaryPolicy,part4:TheFedinAction ThissegmentexplainshowtheFedmovestheeconomytowardmaximumemploymentandpricestabilitybysettingatargetrangeforthefederalfundsrate,andhowitthenusesinterestonreservebalancestosteerthefederalfundsrateintothetargetrange.Thesefactorsaffectconsumerandproducerdecisionsandultimatelythelevelofemploymentandinflation,whichpromoteastrongU.S.economy. PreviewtheVideoQ&AforPart4:TheFedinAction Moreepisodes: TheEconomicLowdownPodcastSeries TheEconomicLowdownVideoSeries Transcripts MonetaryPolicy,part1:TheFedandtheDualMandate   TheFederalReserve,“theFed,”isthecentralbankoftheUnitedStates.OneofitsimportantfunctionsistopromoteastrongU.S.economy.Infact,congresshasgiventheFedtwomaingoals:maximumemploymentandpricestability.ThesegoalsareoftenreferredtoastheFed’s“dualmandate.”TheFedusesmonetarypolicytomovetheeconomytowardthesegoals. Now,pricestabilitydoesn’tmeanthatpricesneverchange.Itmeansthattheinflationrateremainslowandstableoverthelongerrun.TheFed’spolicymakinggroup,theFederalOpenMarketCommittee,oftenreferredtoastheFOMC,hasstatedthatitwouldlikeinflationtoaverage2percentovertime. Maximumemploymentisthehighestlevelofemploymentthattheeconomycansustainovertime.TheFOMCdetermineshowthelabormarketisdoingrelativetohowitcouldpotentiallybedoingatmaximumemployment.Todothis,itlooksatawiderangeofeconomicindicators,includingtheunemploymentrate. SohowdoestheFedtrytoachieveitsdualmandate?TheFedsetsmonetarypolicytostartachainofeventsintheeconomy.Here’showitworks:FirsttheFOMCmeets.Ithas8regularlyscheduledmeetingsayear.Atthesemeetings,thecommitteelooksatdataoncurrenteconomicconditions—whatistrendingupandwhatistrendingdown—andhowtheeconomyislikelytochangegoingforward.Basedonthatinformation,theFOMCmakesamonetarypolicydecision.Specifically,itdecideswhatistheappropriatetargetrangeforthefederalfundsrate,whichisashort-terminterestrate. Withthetargetrangeset,theFedthenusesitspolicytoolstosteerthefederalfundsrateintothistargetrange.Whenthefederalfundsratemoves,itaffectsotherinterestrates,andinterestratesaffectoverallfinancialconditions.Thesefinancialconditionsinturninfluencehowhouseholdsandbusinessesdecidetospendandinvest.Andthosechoicesinturnaffectemploymentandprices. Sohere’showthechainreactionmightwork.Let’ssaytheFOMCthinkstheeconomyisoverheating,withunemploymentverylowandinflationtoohighforaperiodoftime.Tonudgetheeconomyontherighttrack,it’llmovethetargetrangeforthefederalfundsrateup.ThentheFedwilluseitspolicytoolstosteerthefederalfundsrateintothetargetrange,whichencouragesotherinterestratestomoveup.Wheninterestratesarehigher,householdsandbusinessestendtospendandinvestlessandsavemore.Whenspendingdeclines,thereislessdemandforworkersandpricestendtodecline. Nowlet’ssaytheFOMCthinkstheeconomyisweakening,withemploymentfallingshortofitsmaximumlevelorinflationdecliningbelowtarget.InthiscasethecommitteemaymovethetargetrangeforthefederalfundsratedownandtheFedwouldputitstoolstoworktoencouragemarketinterestratestomovedown.Withlowerinterestrates,andeasierfinancialconditionsmorebroadly,householdsandbusinesseswilllikelyspendandinvestmoreandsaveless.Whenspendingincreases,thereismoredemandforworkersandupwardpressureonprices.” ThesearethelinkagesthattheFOMChasinitsmindasitchoosestheappropriatetargetrangeforthefederalfundsratetomovetheeconomytowardtheFed’sdualmandate. ButhowdoestheFedensurethatthefederalfundsrateactuallymovesintothetargetrange?JoinusforPart2tolearnabouttwoimportantinterestratestheFedusestoimplementtheFOMC’spolicysetting. MonetaryPolicy,part2:TwoImportantInterestRatesinMonetaryPolicyImplementation WhentheFederalOpenMarketCommittee,theFOMC,conductsmonetarypolicy,itistakingactionstomanagefinancialconditionsthatencouragetheeconomytomovetowardstheFed’sgoalsofmaximumemploymentandpricestability.Itdoessobysettingatargetrangeforthefederalfundsrate. Butwait,whatisthefederalfundsrate?Itiseasiesttothinkaboutitasashort-terminterestratethatbankschargewhentheylendfundstoanotherbank. Let’smakesurewegetwhatthisimportantinterestrateis.BanksholdfundsinaccountsattheFedcalledreservebalanceaccounts.WhenBankAneedstoborrowfunds,itmightborrowthemfromBankBifBankBhasextrareservebalances.Whenbanksborrowfromeachotherlikethis,it’stypicallyjustovernight.Thenextday,BankAreturnsthefundsplusabitofinteresttoBankB.Thesetransactionsoccurinthefederalfundsmarket,andtheinterestratebanksagreetoisthefederalfundsrate. Onanygivenday,therearemanytransactionsinthefederalfundsmarket,andtheysettleatslightlydifferentfederalfundsrates. Theeffectivefederalfundsrate,measuresthemedianrateofallthesetransactions.TheFOMCsetsthetargetrangeforwhereitwantsthiseffectivefederalfundsratetobeor,inotherwords,amajorityofthetransactionsshouldfallwithinthetargetrange.SohowdoestheFedmakesurethishappens?Itusesoneoftheinterestratesthatitsetscalled“interestonreservebalances.”Asthenameimplies,theFederalReservepaysinterestonthereservebalancesbanksholdintheiraccountsattheirregionalFederalReserveBank. Forbanks,theirreservebalanceaccountoffersasafe,risk-free,overnightinvestmentoption.Iftheyhaveexcessfunds,theycanalwaysdepositthemintotheirreservebalanceaccountandearninterest,justlikeyoucandowithasavingsaccount. Buttheinterestrateonreservebalancesismorethananopportunityforbankstoearninterest.ThisrateisanimportanttoolthattheFedusestosteerthefederalfundsrateintotheFOMC’stargetrange.Andtwoeconomicconceptshelpexplainhowthisprocessworks:reservationrateandarbitrage.JoinusinPart3tofindoutwhatthoseconceptsmeanandhowtheywork. MonetaryPolicy,part3:ReservationRateandArbitrage InthelastepisodeyoulearnedthatbankscanearninterestontheirdepositsattheirFederalReserveBank,ortheycanearninterestbylendingtootherbanksinthefederalfundsmarket.WhenbanksholdfundsinreservebalanceaccountsattheFed,theyearntheinterestonreservebalancesrate.Whenbankslendfundstootherbanksfromtheirreservebalanceaccounts,theyearnthefederalfundsrate. So,whenbankshaveexcessfunds,theylookacrossthesetwooptionstodecidethebestplacetoinvestthem.Becauseofthischoice,theFedusestheinterestonreservebalancesratetosteerthefederalfundsrateintotheFOMC’stargetrange.TheFedknowstheinterestonreservebalancesratewillsteerthefederalfundsrateintothetargetrangebecauseoftwoeconomicforces,reservationrateandarbitrage. Let’sseehoweachoftheseforceswork. Thefirstthingtounderstandiswhatisareservationrate.Areservationrateisthelowestrateofreturnthatabankiswillingtoacceptforlendingoutitsfunds.Becauseabankearnsinterestonthefundsinitsreservebalanceaccount,there’sreallynoneedforittolendthesemoniesoutforanythinglessthanwhatitcangetfromtheFed. Let’slookatanexample. Supposeabankhasonlytwooptionstoinvestitsfundsovernight.Optiononeistodeposititsexcessfundsinitsreservebalanceaccountandearntheinterestonreservebalancesrate.Andoptiontwoistolenditsexcessfundstoanotherbankinthefederalfundsmarketandearnthenegotiatedfederalfundsrate.Thesearebothlow-riskoptionsforthebanktoearninterestovernight. What’sthechoicethebankismostlikelytomake?Itdependsontheinterestrates. Whatiftheinterestonreservebalancesrateis2.5%,whilethefederalfundsrateisaround2%?Well,thebankwillmostlikelychoosethefirstoptions.ThebankwilldeposititsfundsattheFedandearnthehigherrate. Infact,becausebanksseekthebestreturnfortheirmoneyacrosssimilarriskandmaturityoptions,theyareunlikelytolendorinvestinanovernightassetforlessthanitcanearnbydepositingatitsFederalReserveBank.So,forbanks,interestonreservebalancesservesasareservationrate--thelowestrateofreturnthatbanksarewillingtoacceptforlendingoutfunds. Now,howdoestheinterestonreservebalancesratesteerthefederalfundsrate?Meaning,inthiscase,helptopullthefederalfundsrateup?Theanswerhastodowitharbitrage.Arbitragehereisthesimultaneouspurchaseandsaleoffundsinordertoprofitfromadifferenceininterestrates.Arbitrageensuresthatthefederalfundsratewillstayneartotheinterestonreservebalancesratebecausearbitragewillclosethegapbetweenthetworates. Let’sgobacktoourexample: Recalloptiononehastheinterestonreservebalancesrateat2.5percentandoptiontwohasthefederalfundsrateat2percent,thefederalfundsratewillbepulledup.Why?Well,inthiscase,bankswillborrowfundsinthefederalfundsmarketata2%rateandimmediatelydepositthosesamefundsattheFedandearn2.5%rate.Thisactionisarbitrage.Theprofitis50basispoints,or½percentagepoint,foreverydollarinvested. Now,anybankcandothis—borrowinthefederalfundsmarketanddepositthosefundsattheFedtoearnaprofit. Whenmoreandmorebankswanttoborrowinthefederalfundsmarket,thecompetitionforloansincreasesandlenderswilltostartchargeabitmore.Thatis,thefederalfundsratewillstarttorise.Infact,arbitrageshouldcontinueuntilthefederalfundsraterisestoalevelthatbanksnolongerhavetheopportunitytoprofit. So,arbitrageensuresthatthefederalfundsrateneverfallstoofarbelowtheinterestonreservebalancesrate.Andarbitragewouldalsoensurethatthefederalfundsratewouldneverbetoofarabovetheinterestonreservebalancesrate. Giventhattheseeconomicconceptsarealwaysworkinginthebackground,theFedcaneffectivelyuseinterestonreservebalancestoensuremarketratesmoveasdesired. Forexample,WhentheFOMCincreasesthetargetrange,theFedraisestheinterestonreservebalancesrate. Arbitragekicksintomakesurethefederalfundsratemovesuptowardtheinterestonreservebalancesrateandwithintherange. Similarly,whentheFOMClowersthetargetrangeforthefederalfundsrate,theFedlowerstheinterestonreservebalancesrate,whichencouragesthefederalfundsratetomovedownintothenewtargetrange. NowweknowhowtheFedisabletosteerthefederalfundsrateintotheFOMC’stargetrange. JoinusforPart4tolearnhowtheFeddecidestosetthepolicyratetohelpmovetheeconomytowarditscongressionallyassigneddualmandate:maximumemploymentandpricestability. MonetaryPolicy,part4:TheFedinAction   Inpart3welearnedhowtheinterestonreservebalancesrateactsasareservationrateforbanks,andhowarbitragesteersthefederalfundsrateintotheFOMC’stargetrange.Nowlet’sturntohowtheFOMCdecidesontheappropriatelevelforthetargetrange. Itmightbeeasiesttothinkaboutasituationwheretheeconomyseemstobeweakening. SupposetheFOMCismeetingandlookingattheeconomicdata.Afterathoroughreview,theFOMCdeterminesthatemploymentorinflationistoolow.And,economicdatasuggesttheeconomymayweakenfurther.Inthiscase,theFOMCmightdecidetouse“expansionary"or“accommodative”monetarypolicytoprovidestimulusfortheeconomy.Thatis,theFOMCcouldloweritstargetrangeforthefederalfundsrateandtheFedwoulddecreasetheinterestonreservebalancesrate.Forexample,iftheFOMClowersthetargetrangeby25basispoints—whichis¼percent,thentheFedislikelytoalsolowertheinterestonreservebalancesrateby25basispoints. Becauseoftheeconomicconceptsofreservationrateandarbitrage,theloweringoftheinterestonreservesbalancesratepullstheinterestratethatbankschargeeachotherinthefederalfundsmarketdown.Whenthefederalfundsratedeclines,itstartsachainreaction:otherinterestratestendtofollow,whichthenaffectsoverallfinancialconditions.Wheninterestratesdecline,thecostofborrowingmoneydeclines,whichencourageshouseholdstoincreasespendingandbusinessestoincreaseinvestment.Asspendingincreases,sowillproduction,andbusinessesarelikelytohireadditionalemployeesandspendmoreonotherresources.Astheseincreasesinspendingripplethroughtheeconomy,unemploymentdecreases,movingtheunemploymentratedowntowarditsfullemploymentlevel,andinflationpossiblymovesup. So,whentheeconomyisstalling,theFed’smonetarypolicyactions,bothloweringthetargetrangeforthefederalfundsrateandreducingtheinterestonreservebalancesratecanbeeffectiveformovingtheeconomybacktowardsmaximumemploymentandpricestability. So,byincreasingthetargetrangeforthefederalfundsrate,andincreasingtheinterestonreservebalancesrate,theFedcanmovetheeconomybacktowardmaximumemploymentandpricestability. Toconcludeourdiscussionaboutmonetarypolicy,let’ssumupwithafewkeypoints.TheFederalReservehasadualmandatefromcongresstopromotemaximumemploymentandpricestability.TheFedmovestheeconomytowardthesegoalsbysettingatargetrangeforthefederalfundsrate.TheFedusesinterestonreservebalancesasitsprimarypolicytooltosteerthefederalfundsrateintothetargetrange.Thesettingofmonetarypolicyaffectsotherinterestrates,whichultimatelyinfluencebroaderfinancialconditions.Thesefactorsaffectconsumerandproducerdecisionsandultimatelythelevelofemploymentandinflation,whichpromoteastrongU.S.economy. SonowyouknowwhatitmeanswhenyouhearnewsreportsthattheFedraisedorloweredinterestrates.ItisreallythattheFOMCadjusteditstargetrangeand,becauseofeconomicconceptslikereservationrateandarbitrage,marketinterestratesmovedappropriately,andthisaffectedconsumerandbusinessdecisions.Thisisalldonetomovetheeconomyforwardinahealthymannertomaximizeemploymentandkeepingpricesstable. --- Ifyouhavedifficultyaccessingthiscontentduetoadisability,[email protected]. FindMoreEconomicsandPersonalFinanceResources EducationLevel: 6-8 ,  9-12 ,  College ,  Non-educators Subjects: APEconomics ,  Economics Concepts: FederalReserveSystem-functions ,  MonetaryPolicy ,  Employment ,  Inflation/Deflation ResourceTypes: Video Languages: English