Decisions by central banks, such as the Federal Reserve in the United States, to affect a nation's supply of money and availability of credit constitute monetary policy. Through the three primary tools of monetary policy, central banks in the U.S. and other countries try to ensure conditions that are favorable to stable economic growth and low levels of inflation.
Central banks oversee the banking system and supply of money for their respective nations. In addition to the Federal Reserve (also known as "the Fed"), other examples of central banks include the Bank of England, the Bank of Japan and the Bank of Canada. Within the Federal Reserve System, the Federal Open Market Committee is the panel that sets U.S. monetary policy. This committee, consisting of the Fed chairman and board of governors, as well as five Federal Reserve bank presidents, meets eight times a year in Washington, D.C. to review the latest economic data and set monetary policy. Tools that the Fed uses to affect monetary policy consist of short-term interest rates, open market operations and reserve requirements.
Short-Term Interest Rates
The Fed's primary monetary policy tool is the federal funds rate, the interest rate that banks charge each other for overnight loans. When banks need additional reserves for a short term, they borrow from other banks that have excess reserves. Fed policymakers adjust the federal funds rate in response to economic conditions. If the Fed wants to control inflationary pressures in the economy, policymakers increase the funds rate. If the Fed wants to loosen credit to stimulate the economy during a recession, it decreases the funds rate.
In addition to the federal funds rate, Fed policymakers control another short-term interest rate known as the discount rate. This is the interest rate the Fed charges banks for lending reserves directly. Since 2003, the Fed has set the discount rate higher than the federal funds rate to encourage banks to borrow on the cheaper federal funds market before turning to the Fed itself.
Open Market Operations
Open market operations involve the sale and purchase of government securities on the open market. The Federal Reserve Bank of New York conducts the Fed's open market operations. Whether the Fed buys or sells securities depends on its decision regarding the federal funds rate, according to the Federal Reserve Bank of San Francisco. If the Fed votes to lower the rate, it buys government securities from banks and pays for them by increasing the banks' reserves. Banks hold money in reserve in their vaults or as deposits with the Fed.
All banks are required by law to hold funds in reserve to clear checks, stock ATMs and meet other obligations. The Federal Reserve Bank of San Francisco reports that most banks hold more reserves than required. When the Federal Open Market Committee raises the federal funds rate, some banks may need to borrow additional reserves.
Monetary policy decisions by the Fed and other central banks take time to affect the economy. The Federal Reserve Bank of San Francisco estimated that affects on output can take between three months and two years, while affects on inflation could require one to three years.