The Central Bank of a country has the power to influence the supply and value of money and credit in the economy to achieve certain economic objectives. The Central Bank undertakes certain actions for this purpose and this implementation is called the “Monetary Policy”. …
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The depository institutions of the economy hold some balances with the Federal Reserve Bank. The depository institutions also lend balances at the Federal Reserve to other such institutions overnight. The interest rate at which these balances are lent is known as the federal funds rate. The Federal Reserve, with the help of its three policy instruments, influences the demand and supply of these balances held by the depository institutions at the Federal Reserve and thus also changes the federal funds rate. As the federal funds rate changes, this starts a sequence of activities which influences other short term interest rates, long term interest rates, foreign exchange rates, amount of money and credit circulating in the economy, employment, output, the prices of goods and services and many other economic variables. (Board of Governors of the Federal Reserve System, 2011)
The Three Main Tools of Monetary Policy
Open Market Operations: Under the open market operations, the Federal Reserve Bank buys and sells U.S Treasury bills and federal agency securities in the market. These operations are usually conducted to achieve a desired level of balance reserves which the depository institutions hold with the Federal Reserve. The operations can be conducted to achieve a desired value of the federal funds rate too. Usually, the short-term objectives of the open market operations are specified by the Federal Open Market Committee
m, 2011) (Board of Governors of the Federal Reserve System, 2011) The Discount Rate: The Federal Reserve Bank has its branches located in the different regions of USA. These regional Reserve Banks have a lending facility called the discount window through which they extend loans to the commercial banks and other depository institutions of that region. The interest rate charged on these loans is the discount rate. The Federal Reserve Banks offer three types of loans through their discount windows: primary credit, secondary credit and seasonal credit, extended at their respective discount rates. The primary credit discount rate is stipulated above the short-term market interest rate level. The secondary credit discount rate is set above the primary discount rate. The seasonal credit discount rate is determined by calculating an average of selected market interest rates. The regional Reserve Bank’s Board of Directors determines their respective discount rates, although they remain to the review of Board of Governors of the central Federal Reserve Bank. The funds borrowed by the Commercial Banks from the Federal Reserve Bank from January- July 2011 can be seen from the following table: (Board of Governors of the Federal Reserve System, 2011) (Board of Governors of the Federal Reserve System, 2011) Reserve Requirements: The Federal Reserve Bank stipulates an amount of funds that the depository agents should keep as reserves against specific amount of deposit liabilities. These are known as reserve requirements. The depository institutions usually hold these reserve requirements in the form of deposits or vault cash with the Federal Reserve Bank. Only the Board of Governors of the Federal Reserve Bank holds the power to change the reserve requirements. (Board of Governors
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