How the Federal Reserve Devises Monetary Policy

The Federal Reserve, the central bank in the U.S., uses open market operations, discount rates, and reserve requirements to formulate monetary policies. · The ... TableofContents Expand TableofContents WhatIstheFederalFundsRate? WhatAreOpenMarketOperations? WhatIstheDiscountRate? WhatAreReserveRequirements? MonetaryPolicyFAQs TheBottomLine MonetaryPolicy FederalReserve Partof HowTheFed’sInterestRatesAffectConsumers PartOf HowTheFed’sInterestRatesAffectConsumers ExploreTheGuide Overview TheFederalReserve Overview CentralBanks WhatistheFederalReserve? TheTreasuryandtheFederalReserve PrimeRatevsDiscountRate HowTheFedInfluencestheEconomy InterestRates Overview FedFundsRate WhatChangesInterestRates? RisingInterestRates InterestRates&Investments InterestRates&MoneySupply Real,Nominal&EffectiveInterestRates NegativeInterestRates MonetaryPolicy Overview WhatisMonetaryPolicy? MoneySupply QuantitativeEasing Fiscalvs.MonetaryPolicy HowtheFedDevisesMonetaryPolicy InterestRateImpactonConsumers Overview HowtoPrepareforRisingInterestRates HowtoInvestforRisingInterestRates HowAreMoneyMarketInterestRatesDetermined? OpenMarketOperationsvs.QuantitativeEasing:What'stheDifference? InterestRateRiskBetweenLong-TermandShort-TermBonds HowHigherInterestRatesImpactYour401(K) InterestRateRippleEffectsonMarkets Overview HowInterestRatesAffectU.S.Markets AverageCreditCardInterestRate TheMostImportantFactorsAffectingMortgageRates HowInterestRatesWorkonCarLoans TheseSectorsBenefitfromRisingInterestRates HowBanksSetInterestRatesonYourLoans Monetarypolicyishowacentralbank(alsoknownasthe"bank'sbank"orthe"bankoflastresort")influencesthedemand,supply,priceofmoney,andcredittodirectanation'seconomicobjectives.FollowingtheFederalReserveActof1913,theFederalReserve(theU.S.centralbank)wasgiventheauthoritytoformulateU.S.monetarypolicy.Todothis,theFederalReserveusesthreetools:openmarketoperations,thediscountrate,andreserverequirements. WithintheFederalReserve(alsoknownasTheFed),theFederalOpenMarketCommittee(FOMC)isresponsibleforimplementingopenmarketoperations,whiletheBoardofGovernorslooksafterthediscountrateandreserverequirements. KeyTakeaways TheFederalReserve,thecentralbankintheU.S.,usesopenmarketoperations,discountrates,andreserverequirementstoformulatemonetarypolicies.TheFederalReservechargesafederalfundsratetodepositoryinstitutionsthatlendtheirfederalfundstootherdepositoryinstitutions.Open-marketoperationsinvolvebuyingandsellinggovernment-issuedsecurities.ThediscountrateistheinterestratebanksandsimilarinstitutionsarechargedtoborrowReservefunds. WhatIstheFederalFundsRate? Thethreeinstrumentswementionedaboveareusedtogethertodeterminethedemandandsupplyofthemoneybalancesthatdepositoryinstitutions,suchascommercialbanks,holdatFederalReservebanks.ThedollaramountplacedwiththeFederalReservechangesthefederalfundsrate.ThisistheinterestrateatwhichbanksandotherdepositoryinstitutionslendtheirFederalBankdepositstootherdepositoryinstitutions. Bankswilloftenborrowmoneyfromeachothertocovertheircustomers'demandsfromonedaytothenext,sothefederalfundrateisessentiallytheinterestratethatonebankchargesanotherforborrowingmoneyovernight.ThemoneyloanedouthasbeendepositedintotheFederalReservebasedonthecountry'smonetarypolicy. Thefederalfundsrateiswhatestablishesothershort-termandlong-terminterestratesandforeigncurrencyexchangerates.Italsoinfluencesothereconomicphenomena,suchasinflation.Todetermineanyadjustmentsthatmaybemadetomonetarypolicyandthefederalfundsrate,theFOMCmeetseighttimesayeartoreviewthenation'seconomicsituationconcerningeconomicgoalsandtheglobalfinancialsituation. WhatAreOpenMarketOperations? Openmarketoperationsareessentiallythebuyingandsellingofgovernment-issuedsecurities(suchasU.S.T-bills)bytheFederalReserve.Itistheprimarymethodbywhichmonetarypolicyisformulated.Theshort-termpurposeoftheseoperationsistoobtainapreferredamountofreservesheldbythecentralbanktoalterthepriceofmoneythroughthefederalfundsrate. WhentheFederalReservedecidestobuyT-billsfromthemarket,itaimstoincreaseliquidityinthemarket,orthesupplyofmoney,whichdecreasesthecostofborrowing,ortheinterestrate. Ontheotherhand,adecisiontosellT-billstothemarketisasignalthattheinterestratewillbeincreased.Thisisbecausetheactionwilltakemoneyoutofthemarket(toomuchliquiditycanresultininflation),thusincreasingthedemandformoneyanditscostofborrowing. WhatIstheDiscountRate? ThediscountrateisessentiallytheinterestratethatbanksandotherdepositoryinstitutionsarechargedtoborrowfromtheFederalReserve.Underthefederalprogram,qualifieddepositoryinstitutionscanreceivecreditunderthreedifferentfacilities:primarycredit,secondarycredit,andseasonalcredit. Eachformofcredithasitsowninterestrate,buttheprimaryrateisgenerallyreferredtoasthediscountrate. Theprimaryrateisusedforshort-termloans,whichareextendedovernighttobankinganddepositoryfacilitieswithasolidfinancialreputation.Thisrateisusuallyputabovetheshort-termmarket-ratelevels. Thesecondarycreditrateisslightlyhigherthantheprimaryrateandisextendedtofacilitiesthathaveliquidityproblemsorseverefinancialcrises. Finally,seasonalcreditisforinstitutionsthatneedextrasupportonaseasonalbasis,suchasafarmer'sbank. Seasonalcreditratesareestablishedfromanaverageofchosenmarketrates. WhatAreReserveRequirements? ThereserverequirementistheamountofmoneythatadepositoryinstitutionisobligatedtokeepinFederalReservevaultstocoveritsliabilitiesagainstcustomerdeposits. SinceDecember1990,non-personaltimedepositsandeuro-currencyliabilitieshavehadreserveratiorequirementsofzero(meaningnoreserveshavetobeheldforthesetypesofaccounts). TheBoardofGovernorsdecidestheratioofreservesthatmustbeheldagainstliabilitiesthatfallunderreserveregulations.Thus,theactualdollaramountofreservesheldinthevaultdependsontheamountofthedepositoryinstitution'sliabilities. Liabilitiesthatmusthavereservesagainstthemincludenettransactionaccounts,non-personaltimedeposits,andeuro-currencyliabilities. HowDoestheFederalReserveAffectMonetaryPolicy? ThecentralbankintheU.S.,theFederalReserve,usesavarietyoftoolstoeffectmonetarypolicy.Thesetoolsincludethereserverequirementsrequiredbymemberbanks,changesininterestrates,andopenmarketoperations,whichinvolvesthepurchaseofTreasuriesandothersecurities. WhatIstheDifferenceBetweenMonetaryPolicyandFiscalPolicy? Monetarypolicyconsistsofactionstakenbyacountry'scentralbank,suchasthechangesininterestratesandtheestablishmentofreserverequirementsforbanks.Fiscalpolicy,ontheotherhand,consistsofactionstakenbyacountry'slegislativebranch.Theseincludeactionssuchaschangesintaxpolicyandgovernmentspending. WhatAretheDisadvantagesofMonetaryPolicy? Thedisadvantagesofmonetarypolicyincludeatimelag,inthatresultsarenotseenimmediatelybutmuchlaterafterapolicyisenacted;theyareblanketpoliciesthattargetanentirenationratherthanspecificgroups,sotherearealwayswinnersandlosers;dependingonthepolicy,thereisariskofinflationorarecession,andthereisnoguaranteethattheywillwork. TheBottomLine Byinfluencingthesupply,demand,andcostofmoney,thecentralbank'smonetarypolicyaffectsthestateofacountry'seconomicaffairs.Byusinganyofitsthreemethods—openmarketoperations,discountrate,orreserverequirements—theFederalReservebecomesdirectlyresponsibleforprevailinginterestratesandotherrelatedeconomicsituationsthataffectalmosteveryfinancialaspectofourdailylives. ArticleSources Investopediarequireswriterstouseprimarysourcestosupporttheirwork.Theseincludewhitepapers,governmentdata,originalreporting,andinterviewswithindustryexperts.Wealsoreferenceoriginalresearchfromotherreputablepublisherswhereappropriate.Youcanlearnmoreaboutthestandardswefollowinproducingaccurate,unbiasedcontentinour editorialpolicy. FederalReserve."RegulationDReserveRequirements,"Page1. 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Provider Name Description PartOf HowTheFed’sInterestRatesAffectConsumersGuide TheImpactofInterestRateChangesbytheFederalReserve 1of30 CentralBankDefinition 2of30 FederalReserveSystem(FRS) 3of30 U.S.Treasuryvs.FederalReserve:What’stheDifference? 4of30 PrimeRatevs.DiscountRate:What'stheDifference? 5of30 TheFed'sToolsforInfluencingtheEconomy 6of30 FederalFundsRate 7of30 WhatAretheForcesBehindInterestRatesandWhatCausesThemtoRise? 8of30 WhatHappensIfInterestRatesIncreaseTooQuickly? 9of30 DoLowerInterestRatesIncreaseInvestmentSpending? 10of30 HowDoesMoneySupplyAffectInterestRates? 11of30 InterestRatesExplained:Nominal,Real,Effective 12of30 LearnHowNegativeInterestRatesWork 13of30 WhatIsMonetaryPolicy? 14of30 HowtheFederalReserveManagesMoneySupply 15of30 QuantitativeEasing(QE) 16of30 FiscalPolicyvs.MonetaryPolicy:ProsandCons 17of30 HowtheFederalReserveDevisesMonetaryPolicy 18of30 HowtoPrepareforRisingInterestRates 19of30 HowtoInvestforRisingInterestRates 20of30 DeterminingMoneyMarketInterestRates 21of30 OpenMarketOperationsvs.QuantitativeEasing:What’stheDifference? 22of30 InterestRateRiskBetweenLong-TermandShort-TermBonds 23of30 HowHigherInterestRatesImpactYour401(k) 24of30 HowInterestRatesAffecttheU.S.Markets 25of30 WhatisTheAverageCreditCardInterestRate? 26of30 TheMostImportantFactorsThatAffectMortgageRates 27of30 HowInterestRatesWorkonCarLoans 28of30 TheseSectorsBenefitFromRisingInterestRates 29of30 HowBanksSetInterestRatesonYourLoans 30of30 RelatedArticles FederalReserve UnderstandingHowtheFederalReserveCreatesMoney Economics WhatIstheRelationshipBetweenInflationandInterestRates? MonetaryPolicy HowCentralBanksControltheSupplyofMoney Government&Policy HowDoGovernmentsFightInflation? FederalReserve HowtheFederalReserveManagesMoneySupply FederalReserve TheFederalReserveChair'sResponsibilities PartnerLinks RelatedTerms FederalFundsRate ThefederalfundsrateisthetargetinterestratesetbytheFedatwhichcommercialbanksborrowandlendtheirextrareservestooneotherovernight. more OpenMouthOperations OpenmouthoperationsarespeculativestatementsmadebytheFederalReservetoinfluenceinterestratesandinflation. more WhatAreNon-BorrowedReserves? Non-borrowedreservesarebankreservesthatarenotborrowedfromthecentralbank. more TheGo-AroundProcessintheFederalReserve Go-arounddescribestheFederalReserve'sauctionprocessforsolicitingbusinesswithprimarydealers. more CostofFunds:HowMuchInterestBanksHavetoPaytoAcquireFunds Costoffundsreferstotheinterestratepaidbyfinancialinstitutionsforthefundsthattheydeployintheirbusiness. more WhatIstheFederalOpenMarketCommittee(FOMC)? TheFederalOpenMarketCommittee(FOMC)isthebranchoftheFederalReserveSystemthatdeterminesthedirectionofmonetarypolicy. more