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Monetary Policy

 

What is monetary policy?
The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit as a means of helping to promote national economic goals.

Further information on the Federal Reserve and monetary policy is available on the Federal Open Market Committee section of the Board's Web site.


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How does the Federal Reserve implement monetary policy?

The Federal Reserve implements monetary policy using three major tools. Open market operations--purchases and sales of U.S. Treasury and federal agency securities--are the Federal Reserve's principal tool for implementing monetary policy. The short-term objective for open market operations is specified by the Federal Open Market Committee (FOMC). This objective can be a desired quantity of reserves or a desired price (the federal funds rate). The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

The second major monetary policy implementation tool is the discount rate. The discount rate--the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility--is established by the Board of Directors of the Federal Reserve Banks subject to review and determination by the Board of Governors. The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. Further information on the discount window, including discount rates, is available on the Federal Reserve's discount window Web site.

The third major monetary policy implementation tool is reserve requirements. Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Within limits specified by law, the Board of Governors has sole authority over changes in reserve requirements. Reserve requirements are imposed solely for monetary policy purposes. Depository institutions must hold reserves in the form of vault cash or as deposits with Federal Reserve Banks.

The Federal Reserve Banks pay interest on required reserve balances--balances held at Reserve Banks to satisfy reserve requirements--and on excess balances-- balances held in excess of required reserve balances and contractual clearing balances. The interest rate paid on required reserve balances is determined by the Board and is intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions. The interest rate paid on excess balances is also determined by the Board and gives the Federal Reserve an additional tool for the conduct of monetary policy.

Using these tools, the Federal Reserve influences the demand for and supply of balances that depository institutions hold on deposit at Federal Reserve Banks (the key component of reserves) and thus the federal funds rate- -the interest rate charged by one depository institution on an overnight sale of balances at the Federal Reserve to another depository institution. Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long- term interest rates, the amount of money and credit in the economy, and, ultimately, a range of economic variables, including employment, output, and the prices of goods and services.



What is the federal funds rate, and why does the FOMC raise or lower the target rate?
The federal funds rate is the rate charged by one depository institution on an overnight sale of immediately available funds (balances at the Federal Reserve) to another depository institution; the rate may vary from depository institution to depository institution and from day to day. The target federal funds rate is set by the Federal Open Market Committee (FOMC). By setting a target federal funds rate and using the tools of monetary policy-- open market operations, discount window lending, and reserve requirements--to achieve that target rate, the Federal Reserve and the FOMC seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," as required by the Federal Reserve Act.

At each of its meeting, the FOMC examines a number of indicators of current and prospective economic developments. Then, cognizant that its actions affect economic activity with a lag, it must decide whether to alter its target for the federal funds rate. An actual decline in the rate stimulates economic growth, but an excessively high level of economic activity can cause inflation pressures to build to a point that ultimately undermines the sustainability of an economic expansion. An actual rise in the rate curbs economic growth and helps contain inflation pressures, and thus can promote the sustainability of an economic expansion; too great a rise, however, can retard economic growth too much. The FOMC's actions on the target federal funds rate are undertaken to achieve the maximum rate of economic growth consistent with price stability and moderate long- term interest rates.

For more information on the federal funds rate, see The Federal Reserve System: Purposes and Functions on the Board of Governors' web site.

Current rate target.

Current actual rate.


What are the historical changes in the target federal funds rate?
Historical changes in the target federal funds rate are available on the Open Market Operations section of the Board's Web site.

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What is the money stock, and how does the Federal Reserve influence it?
Generally, the money stock (also called the "monetary aggregates") consists of two components: M1 and M2. M1 and M2 are progressively more inclusive measures of money: M1 is included in M2. M1, the more narrowly defined measure, consists of the most liquid forms of money, namely currency and checkable deposits. The non-M1 components of M2 are primarily household holdings of savings deposits, small time deposits, and retail money market mutual funds.

The Federal Reserve affects the money stock chiefly by its influence over interest rates. When the Federal Open Market Committee lowers the target federal funds rate, the rate at which depository institutions purchase and sell overnight funds to one another in the market and other short term rates fall. Lower short-term market interest rates increase the attractiveness of the rates paid on deposits at commercial banks and other depository institutions, because changes in these rates tend to lag changes in market rates. Consequently, the public tends to purchase the assets included in the money stock, and money growth increases. Conversely, when the FOMC raises the target federal funds rate, the effective federal funds rate increases along with other short-term interest rates. The rates paid on assets included in the money stock become less attractive, and money growth slows.

For more information, see the current release of money stock measures on the Board's Web site.


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What is the discount rate?
The discount rate is the interest rate that an eligible depository institution is charged by its Federal Reserve Bank to borrow funds, typically for a short period. There are three primary discount rates: the primary credit rate, the secondary credit rate, and the seasonal credit rate. By law, the Board of Directors of each Reserve Bank establishes the discount rate independently every fourteen days subject to review and determination by the Board of Governors.

Originally, each Reserve Bank set its discount rate to reflect the banking and credit conditions in its own District. Over the years, the transition from regional credit markets to a national credit market has gradually produced a national discount rate. As a result, the Federal Reserve maintains a uniform structure of discount rates across all Reserve Banks.

Further information on the discount window, including information on current and historical discount rates, is available on the Federal Reserve Discount Window Web site.


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How does the Federal Reserve maintain the stability of the financial system?
The Federal Reserve's roles in conducting monetary policy, supervising banks, and providing payment services to depository institutions help it maintain the stability of the financial system.

Using the monetary policy tools at its disposal, the Federal Reserve can promote an environment of price stability and reasonably damped fluctuations in overall economic activity that helps foster the health and stability of financial institutions and markets. The Federal Reserve also helps foster financial stability through the supervision and regulation of several types of banking organizations to ensure their safety and soundness. In addition, the Federal Reserve operates certain key payment mechanisms and oversees the operation of the payment system more generally, with the goal of strengthening and stabilizing the system.

The Federal Reserve engages in all these activities on a routine basis, but the stabilization activities of a central bank are especially evident and critical during periods of financial stress, such as those that occurred following the stock market decline of October 1987, the international debt crisis in the fall of 1998, and the terrorist attacks in September 2001. In these instances, the Federal Reserve promoted financial system stability by providing ample liquidity (balances at the Federal Reserve) through large open market purchases of securities (using short-term repurchase agreements) and by extending discount window loans to depository institutions. In unusual and exigent circumstances, the Federal Reserve has the authority to lend to individuals, partnerships, and corporations, but it has never done so.


Where can I obtain copies of the Federal Reserve's Monetary Policy Reports to Congress?
The Board's semiannual Monetary Policy Report to the Congress is available on the Board's Web site. You can order paper copies by writing to the Board of Governors of the Federal Reserve System, Washington, DC 20551, Publications Fulfillment, or by calling (202) 452-3245.

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What are primary dealers?
Primary dealers are banks and securities broker-dealers that trade in U.S. government securities with the Federal Reserve Bank of New York (FRBNY). On behalf of the Federal Reserve System, the FRBNY's Open Market Desk engages in these trades in order to implement monetary policy. The purchase of government securities in the secondary market by the Open Market Desk adds reserves to the banking system; the sale of securities drains reserves.

Further information on primary dealers, together with a current list of designated primary dealers, is available on the Federal Reserve Bank of New York's Web site.


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