Monetary Policy Instruments

The Federal Reserve System has three main policy tools, as well as two additional tools, at its disposal. Each of these is listed and described below. However, the first instrument, open market operations, is by far the most commonly used.

Open Market Operations. Open market operations are the most useful and important of the System’s policy tools. Open market operations are the purchase or sale of government securities by the Federal Reserve System. Each purchase or sale of securities directly affects the volume of reserves in the banking system, and therefore the whole economy. Purchases of government securities increase reserves and ease credit while sales decrease reserves and tighten credit. With a purchase of securities, the System pays for the purchase by crediting the reserve account of the seller’s depository institution. The System can then loan out the reserves and increase the supply of money. Conversely, sales of securities reduce reserves and tighten credit because the System charges the reserve account of the buyer’s bank, decreasing the reserves available for loans.

Open market operations are either “dynamic” or “defensive.” Dynamic operations are those taken to increase or decrease the volume of reserves to ease or tighten credit. Defensive operations are those taken to offset effects of other factors influencing reserves.

The Discount Window. Through their “discount windows,” Reserve Banks act as a safety valve in relieving reserve market pressures. By lending funds against acceptable collateral, the System provides essential liquidity to financial institutions, while helping to assure the basic stability of money markets and the banking system.

Commercial banks once borrowed from Reserve Banks by bringing bonds and other asset documents to a teller’s cage or “window.” The amount loaned was the face value of the asset, minus a “discount.” Today, financial institutions still borrow from Reserve Banks. However, the term “discount window” is simply an expression for Fed loans that are repaid with interest at maturity, arranged by telephone, and secured by pledged collateral.

The discount rate is the interest rate charged to depository institutions on loans from the Federal Reserve’s credit facility, the discount window. Changes in the discount rate are initiated by the boards of directors of the individual Reserve Banks and must be approved by the Board of Governors. This coordination generally results in almost simultaneous changes at all Reserve Banks. The discount rate is changed infrequently.

Changes in the discount rate affect credit conditions and therefore the economy. An increase in the discount rate, for example, makes it more costly for depository institutions to borrow from Reserve Banks. The higher cost discourages depository institutions from using the discount privilege. It may force depository institutions to screen their customers’ loan applications more carefully and slow the growth of their loan portfolios.

Apart from these direct impacts, changes in the discount rate can affect expectations in financial markets. If, for example, the market interprets an increase in the rate as the beginning of a sustained program to tighten credit, lenders will cut back commitments, waiting for more attractive rates. Potential borrowers will try to borrow before the expected higher rates materialize. These actions by lenders and borrowers will produce the expected tight credit.

Reserve Requirements. Reserve requirements are the percentages of deposits that depository institutions must hold as cash in their institution or at the Fed. The reserve requirement affects monetary and financial conditions. For example, a reduction in the reserve requirement decreases the amount of reserves that banks must hold and therefore banks can make more loans. The larger volume of loans creates money and stimulates the economy. Raising the reserve requirement has the opposite effect. Although the reserve requirements are a potentially powerful tool, the Board of Governors seldom changes these requirements in the conduct of monetary policy. Reserve requirements are used more to regulate banks to provide security and stability in the banking system.

In addition to these main tools, the Fed has two additional policy tools at its disposal.

Margin Requirements. Margin requirements are the percentage of cash down payment a purchaser must make when borrowing to buy securities. In some instances, the Board of Governors establishes margin requirements. Although margin requirements could be used actively as a policy instrument, the Board rarely changes the requirements.



Foreign Exchange Operations. As a means of fostering improved international liquidity and offsetting temporary disruptive international capital flows, the System can also engage in the purchase and sale of foreign currencies. Foreign balances generally are purchased in the market or through “swaps” with foreign central banks that credit the account of the System on their books in exchange for a like dollar credit on the books of the Federal Reserve.

Since foreign exchange operations have important effects upon foreign currencies as well as our own, they must be conducted in close cooperation with foreign monetary authorities. Because of similar U. S. Treasury responsibilities in this area, they also are coordinated closely with Treasury actions, which are conducted by the New York Federal Reserve Bank as agent for the Treasury.