Chapter 10.3 How a the Fed Executes Monetary Policy

10.3 How a the Fed Executes Monetary Policy

Learning Objectives

By the end of this section, you will be able to:

• Understand the balance sheet of the Fed
• Explain how the Fed conducts monetary policy
• Understand the difference between expansionary and contractionary monetary policy

The Federal Reserve’s most important function is to conduct the nation’s monetary policy. Monetary policy is a public policy aimed at stabilizing the country’s economy during periods of recession or inflation. Conducting monetary policy refers to regulating the money supply and setting the tone for interest rates in the economy. In other words, monetary policy involves managing interest rates and credit conditions, which influences the level of economic activity, as we describe in more detail below.

Let’s begin by examining the Federal Reserve’s balance sheet. A balance sheet is a financial statement that presents the assets and liabilities of an entity.

Balance Sheet of The Fed

Assets:

The following are the three forms of assets held by the Fed:

Gold: Originally, each dollar was backed by gold; now, it’s backed by the dollar itself. The Fed’s gold holdings stem from purchases of gold made in the 1930s.

Loans: Like commercial banks, the Fed extends loans to other banks. Commercial banks must deposit a portion of their funds with the Fed on a daily basis. If a bank is unable to meet this reserve requirement because of a lack of funds, it can borrow from other banks or from the Fed itself. Loans made by the Fed are recorded on its balance sheet.

US Treasuries: This constitutes the largest asset category. Treasuries include Treasury bills and bonds acquired by the Fed over time from the US Treasury Department.

Remember from chapter 9 – When government spending surpasses total tax revenues, to address this deficit, the government, through the Department of the Treasury, sells government securities also known as treasury bills and bonds. It’s important to note that the treasury cannot print money to cover the deficit.

Who buys the US treasuries? Everyone. Households, firms, foreign government, and the Fed. Over the years, the Federal Reserve has bought many treasury bills and bonds as a tool to conduct monetary policy. The largest portions of the Fed’s assets comprise of Treasury bonds.

Liabilities:

The following are the two forms of liabilities the Fed has:

• Notes (money) in circulation: The majority of liabilities consist of currency (notes) in circulation.
• Deposits: these are reserves held by other banks with the Fed, stemming from their daily deposit requirements.

3 Tools to Conduct Monetary Policy

The Fed has three tools to implement monetary policy in the economy:

• Open market operations
• Changing reserve requirement ratios
• Changing the discount rate

Open Market Operations

Open market operations refer to the buying or selling of US Treasuries directed by the Federal Open Market Committee (FOMC) in order to influence the quantity of bank reserves and the level of interest rates in the economy. It is the most common monetary policy tool. The specific interest rate targeted in open market operations is the federal fund rate. The name “federal fund rate” which is the interest rate that commercial banks charge each other making overnight loans (and NOT the interest rate charged by the Fed). The Fed fund rate is the benchmark interest rate in the economy. In other words, when the fed fund rate increases, all other interest rates in the economy increases, when the fed fund rate falls, all other interest rate falls. The Fed target this rate through open market operations.

Changing Reserve Requirement Ratios

The reserve requirement ratio is the percent of all deposits banks must keep aside as reserves, available for costumer withdrawals. The reserve requirement ratio is determined by the Fed. The Fed can decide to increase or decrease the reserve ratio.

Changing the Discount Rate

The discount rate is the interest rate that the Fed charges commercial banks and other depositary institutions for its loans. The Fed can decide to increase or decrease the reserve ratio.

Two Types of Monetary Policy

There are two types of monetary policies:

Expansionary monetary policy

Contractionary monetary policy

Monetary policy, much like fiscal policy, serves as a crucial tool to stabilize the economy during times of recession and high unemployment, or to combat and prevent inflation. During recessions, expansionary monetary policy, also known as loose monetary policy, is implemented to stimulate economic activity. This involves increasing the money supply, making borrowing easier, and encouraging investment, which in turn boosts GDP. For instance, households may take out loans to purchase homes, while businesses may borrow to expand operations, both contributing to increased investment and economic growth.

Conversely, contractionary monetary policy, or tight monetary policy, is employed during periods of excessive economic growth leading to inflation. This policy aims to reduce the money supply, leading to higher interest rates, reduced borrowing, and ultimately slowing down GDP growth to curb inflation. This measure is necessary when the economy is “overheating” due to rapid GDP expansion.

How to conduct monetary policy

During periods of recession and high unemployment, the Federal Reserve employs expansionary monetary policy, also known as loose monetary policy, to bolster the economy by increasing the money supply and making more funds available for loans. The Federal Reserve has three main methods to achieve this:

• Reducing the reserve requirement ratio, which frees up funds for lending as banks are required to hold less money in reserves, thus increasing the availability of loans.
• Lowering the discount rate, which encourages borrowing by making loans cheaper and consequently increasing the money supply.
• Utilizing open market operations, the Fed buys US Treasuries, to inject money into the economy and further bolster the money supply.

Conversely, in order to curb or prevent inflation, the Federal Reserve implements contractionary monetary policy, also known as tight monetary policy, with the aim of reducing the money supply and slowing down economic growth to maintain price stability. The Federal Reserve employs three primary strategies for this purpose:

• Increasing the reserve requirement ratio, requiring banks to hold a higher percentage of deposits as cash reserves, thus reducing the amount of money available for loans and contracting the money supply.
• Raising the discount rate, which prompts banks to borrow less from the Federal Reserve, subsequently reducing the availability of funds for loans and further contracting the money supply.
• Employing open market operations The Fed sells US Treasuries, to withdraw money from the economy and decrease the money supply.

This chapter was created by Karen David and is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License.