How Does the U.S. Monetary Policy Work?
Monetary policy in the United States is the responsibility of the Federal Reserve ("the Fed"), the nation's central banking authority. Federal Reserve policymakers meet about eight times a year to set monetary policy. They examine data on the state of the economy at the time and review forecasts of future economic conditions. Through monetary policy, the Federal Reserve affects the nation's money supply and helps shape the direction of the economy.
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Identification
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The Fed's Federal Open Market Committee (FOMC) is the body responsible for monetary policy decisions. The Federal Reserve chairman, a presidential appointee, chairs the FOMC, which also consists of seven members of the Fed's Board of Governors and the presidents of five of the nation's 12 Federal Reserve Banks. Membership rotates among the presidents of the 12 banks, but the Federal Reserve Bank of New York is always represented because of New York's importance as a financial center.
The FOMC meets about every six weeks in Washington, D.C., to assess current economic conditions and set monetary policy. Through monetary policy, FOMC strives to ensure stable economic growth, protect the purchasing power of money, and minimize inflation, which negatively affects the value of money and slows economic growth.
Types
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The Fed's tools of monetary policy include setting short-term interest rates, changing banks' reserve requirements and open market operations. Key short-term interest rates include the discount rate, which the Fed charges for lending to banks and the federal funds rate, which banks charge each other for loans. Reserve requirements affect the amount of money that banks must hold in reserve against deposits. Open market operations involve buying and selling government bonds.
The Fed can use these tools to pursue expansionary or contractionary monetary policy, depending on economic conditions. When the economy is sluggish, such as in a recession, the Fed may pursue expansionary policy, expanding the money supply to increase consumer spending and other economic activity. When inflation threatens economic conditions, the Fed uses contractionary policy, reducing the money supply to prevent the economy from growing too fast and sparking inflation.
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Interest Rates
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Fed policymakers affect the money supply through short-term interest rates such as the discount rate and the federal funds rate. An increase in the discount rate or federal funds rate, which the Fed may set to stem inflation, discourages banks from borrowing from the Fed or other banks by making it more costly to borrow. This reduces banking reserves, which in turn, reduces the money supply. A lower discount rate or federal funds rate encourages banks to borrow more, which puts more money into circulation.
Reserve Requirements
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Reserve requirements affect the amount of money that banks must hold against deposits. Higher reserve requirements mean that banks must hold more reserves, leaving them less money to lend, which reduces the money supply. Lower reserves increase the amount of money available to lend, which increases the money supply.
Fed policymakers rarely alter reserve requirements because frequent changes would be too disruptive to the banking industry.
Open Market Operations
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The Fed can affect the money supply through the sale and purchase of government bonds. To increase the money supply, the FOMC directs bond traders at the Federal Reserve Bank of New York to buy bonds. The money the Fed pays for the bonds increases the number of dollars circulating in the economy. To decrease the money supply, FOMC does the opposite: instruct traders to sell bonds to the public. The money paid by the public for these bonds reduces the amount of money in circulation. Open market operations are the most frequently used monetary policy tool.
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