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2012-03-19 12:03:25
December 31 2011 | Filed Under Banking , Economics , Laws
A monetary policy is the means by which a central bank (also known as the
"bank's bank" or the "bank of last resort") influences the demand, supply and,
hence, price of money and credit, in order to direct a nation's economic
objectives. Following the Federal Reserve Act of 1913, the Federal Reserve (the
U.S. central bank) was given the authority to formulate U.S. monetary policy.
To do this, the Federal Reserve uses three tools: open market operations, the
discount rate and reserve requirements.
Tutorial: Introduction To The Federal Reserve
Within the Federal Reserve, the Federal Open Market Committee (FOMC) is
responsible for implementing open market operations, while the Board of
Governors looks after the discount rate and reserve requirements.
The Federal Fund Rate
The three instruments we mentioned above are used together to determine the
demand and supply of the money balances that depository institutions, such as
commercial banks, hold at Federal Reserve banks. The dollar amount placed with
the Federal Reserve in turn changes the federal fund rate. This is the interest
rate at which banks and other depository institutions lend their Federal Bank
deposits to other depository institutions; banks will often borrow money from
each other to cover their customers' demands from one day to the next. So, the
federal fund rate is essentially the interest rate that one bank charges
another for borrowing money overnight. The money loaned out has been deposited
into the Federal Reserve based on the country's monetary policy.
The federal fund rate is what establishes other short-term and long-term
interest rates and foreign currency exchange rates. It also influences other
economic phenomena, such as inflation. To determine any adjustments that may be
made to monetary policy and the federal fund rate, the FOMC meets eight times a
year to review the nation's economic situation in relation to economic goals
and the global financial situation. (To learn about the relationship between
inflation and bonds read Understanding Interest Rates, Inflation And The Bond
Market.)
Open Market Operations
Open market operations are essentially the buying and selling of
government-issued securities (such as U.S. T-bills) by the Federal Reserve. It
is the primary method by which monetary policy is formulated. The short-term
purpose of these operations is to obtain a preferred amount of reserves held by
the central bank and/or to alter the price of money through the federal fund
rate.
When the Federal Reserve decides to buy T-bills from the market, its aim is to
increase liquidity in the market, or the supply of money, which decreases the
cost of borrowing, or the interest rate.
On the other hand, a decision to sell T-bills to the market is a signal that
the interest rate will be increased. This is because the action will take money
out of the market (too much liquidity can result in inflation), therefore
increasing the demand for money and its cost of borrowing. (To learn more read
How The Federal Reserve Manages Money Supply.)
The Discount Rate
The discount rate is essentially the interest rate that banks and other
depository institutions are charged to borrow from the Federal Reserve. Under
the federal program, qualified depository institutions can receive credit under
three different facilities: primary credit, secondary credit and seasonal
credit. Each form of credit has its own interest rate, but the primary rate is
generally referred to as the discount rate.
The primary rate is used for short-term loans, which are basically extended
overnight to banking and depository facilities with a solid financial
reputation. This rate is usually put above the short-term market-rate levels.
The secondary credit rate is slightly higher than the primary rate and is
extended to facilities that have liquidity problems or severe financial crises.
Finally, seasonal credit is for institutions that need extra support on a
seasonal basis, such as a farmer's bank. Seasonal credit rates are established
from an average of chosen market rates. (For more read Internal Rate of Return:
An Inside Look.)
Reserve Requirements
The reserve requirement is the amount of money that a depository institution is
obligated to keep in Federal Reserve vaults, in order to cover its liabilities
against customer deposits. The Board of Governors decides the ratio of reserves
that must be held against liabilities that fall under reserve regulations.
Thus, the actual dollar amount of reserves held in the vault depends on the
amount of the depository institution's liabilities.
Liabilities that must have reserves against them include net transactions
accounts, non-personal time deposits and euro-currency liabilities; however, as
of Dec. 1990, the latter two have had reserve ratio requirements of zero
(meaning no reserves have to be held for these types of accounts).
The Bottom Line
By influencing the supply, demand and cost of money, the central bank's
monetary policy affects the state of a country's economic affairs. By using any
of its three methods - open market operations, discount rate or reserve
requirements - the Federal Reserve becomes directly responsible for prevailing
interest rates and other related economic situations that affect almost every
financial aspect of our daily lives. (Want more information on how the Fed
influences the economy? Read The Fed's New Tools For Manipulating The Economy.)
by Reem Heakal