98 How a Central Bank Executes Monetary Policy
Laura Prince and OpenStax
How a Central Bank Executes Monetary Policy
Learning Objectives
By the end of this section, you will be able to:
- Explain the reason for open market operations
- Evaluate reserve requirements and discount rates
The Federal Reserve’s most important function is to conduct the nation’s monetary policy. Article I, Section 8 of the U.S. Constitution gives Congress the power “to coin money” and “to regulate the value thereof.” As part of the 1913 legislation that created the Federal Reserve, Congress delegated these powers to the Fed. Monetary policy involves managing interest rates and credit conditions, which influences the level of economic activity, as we describe in more detail below.
Watch for simple overview of Monetary Policy: https://www.federalreserve.gov/aboutthefed/conducting-monetary-policy-video.htm
Federal Reserve Monetary Policy Tools
A central bank has three traditional tools to implement monetary policy in the economy:
- Open market operations
- Changing reserve requirements
- Changing the discount rate
In discussing how these three tools work, it is useful to think of the central bank as a “bank for banks”—that is, each private-sector bank has its own account at the central bank. We will discuss each of these monetary policy tools in the sections below.
Open Market Operations (Will change Interest Rate)
The interest rate is the price money. For example, if you need or want to use a savers money – how much will you pay to do that? That is interest. The major interest rates that will affect many other interest rates are the discount rate and the supply and demand of money caused from opens market operations. If there is more money in circulation – the supply goes up – then the price or the interest rate goes down causing more people and businesses to want use it or borrow it. to
Since the early 1920s, the most common monetary policy tool in the U.S. has been open market operations. These take place when the central bank sells or buys U.S. Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates. The specific interest rate targeted in open market operations is the federal funds rate. The name is a bit of a misnomer since the federal funds rate is the interest rate that commercial banks charge making overnight loans to other banks. As such, it is a very short term interest rate, but one that reflects credit conditions in financial markets very well.
The Federal Open Market Committee (FOMC) makes the decisions regarding these open market operations. The FOMC comprises seven members of the Federal Reserve’s Board of Governors. It also includes five voting members who the Board draws, on a rotating basis, from the regional Federal Reserve Banks. The New York district president is a permanent FOMC voting member and the Board fills other four spots on a rotating, annual basis, from the other 11 districts. The FOMC typically meets every six weeks, but it can meet more frequently if necessary. The FOMC tries to act by consensus; however, the Federal Reserve’s chairman has traditionally played a very powerful role in defining and shaping that consensus. For the Federal Reserve, and for most central banks, open market operations have, over the last few decades, been the most commonly used tool of monetary policy.
Link It Up
Visit this website for the Federal Reserve to learn more about current monetary policy.
Clear It Up
Does selling or buying bonds increase the money supply?
Is it a sale of bonds by the central bank which increases bank reserves and lowers interest rates or is it a purchase of bonds by the central bank? The easy way to keep track of this is to treat the central bank as being outside the banking system. When a central bank buys bonds, money is flowing from the central bank to individual banks in the economy, increasing the money supply in circulation. When a central bank sells bonds, then money from individual banks in the economy is flowing into the central bank—reducing the quantity of money in the economy.
The interest rate is the price money. For example, if you need or want to use a savers money – how much will you pay to do that? That is interest. The major interest rates that will affect many other interest rates are the discount rate and the supply and demand of money caused from opens market operations. If there is more money in circulation – the supply goes up – then the price or the interest rate goes down causing more people and businesses to want use it or borrow it. to The second traditional method for conducting monetary policy is to raise or lower the discount rate. If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserves from the Fed, and instead call in loans to replace those reserves. Since fewer loans are available, the money supply falls and market interest rates rise. If the central bank lowers the discount rate it charges to banks, the process works in reverse.
In recent decades, the Federal Reserve has made relatively few discount loans. Before a bank borrows from the Federal Reserve to fill out its required reserves, the bank is expected to first borrow from other available sources, like other banks. This is encouraged by the Fed charging a higher discount rate than the federal funds rate. Given that most banks borrow little at the discount rate, changing the discount rate up or down has little impact on their behavior. More importantly, the Fed has found from experience that open market operations are a more precise and powerful means of executing any desired monetary policy.
Changing Reserve Requirements
A potential second method of conducting monetary policy is for the central bank to raise or lower the reserve requirement, which, as we noted earlier, is the percentage of each bank’s deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank. If banks are required to hold a greater amount in reserves, they have less money available to lend out. If banks are allowed to hold a smaller amount in reserves, they will have a greater amount of money available to lend out.
Until very recently, the Federal Reserve required banks to hold reserves equal to 0% of the first $14.5 million in deposits, then to hold reserves equal to 3% of the deposits up to $103.6 million, and 10% of any amount above $103.6 million. The Fed makes small changes in the reserve requirements almost every year. For example, the $103.6 million dividing line is sometimes bumped up or down by a few million dollars. Today, these rates are no longer in effect; as of March 2020 (when the pandemic-induced recession hit), the 10% and 3% requirements were reduced to 0%, effectively eliminating the reserve requirement for all depository institutions.
The Fed rarely uses large changes in reserve requirements to execute monetary policy; the pandemic was an exception for obvious reasons. Also, a sudden demand that all banks increase their reserves would be extremely disruptive and difficult for them to comply. While loosening requirements too much might create a danger of banks’ inability to meet withdrawal demands, the benefits of reducing the reserve requirements in March 2020 exceeded the risks.
Changing the Discount Interest Rate
In the Federal Reserve Act, the phrase “…to afford means of rediscounting commercial paper” is contained in its long title. This was the main tool for monetary policy when the Fed was initially created. Today, the Federal Reserve has even more tools at its disposal, including quantitative easing, overnight repurchase agreements, and interest on excess reserves.
Summary:
Remember the Goals of Macroeconomics are
- Economic Growth
- Stable Employment
- Stable Prices
Tools of Monetary Policy and Impact on Economy
|
Fed Action |
Impact on $ Supply |
Impact on Interest Rates |
Impact on Economic Growth |
|
Reserve Requirement: Lower Raise |
Increase money supply Decrease money supply |
Reduce int rates Increase int rates
|
Encourage growth R Discourage growth I |
|
Open Market Operation: Buy securities from public Sell securities to public |
Increase money supply Decrease money supply |
Reduce int rates Increase int rates |
Encourage growth R Discourage growth I |
|
Discount Rate/Fed Funds Rate (major interest rate): Lower rate Raise rate |
Increase money supply Decrease money supply |
Reduce int rates Increase int rates |
Encourage growth R Discourage growth I |
R = recessions
I = inflation
Access for free at https://openstax.org/books/principles-economics-3e
