What tools are used by the Federal Reserve to implement monetary policy?
Monetary policy refers to the actions undertaken by the Federal Reserve, which is the central bank, to control credit and its flow within the United States economy. Significantly, what occurs with money and credit influences interest rates and also the performance of the nation’s economy as a whole (Federal Reserve Education, n.d).
The Federal Reserve presently utilizes numerous tools in the implementation of monetary policy about its statutory obligation to nurture maximum employment and stability in prices. The following are the tools:
1. Open market operations (OMO)
The Fed carries out OMO in domestic markets. The terminology open market implies that the Federal Reserve does not decide on its own concerning the kind of securities dealers it will carry out business with on a certain day. Instead, this choice emanates from an open market whereby the different securities dealers that the central bank conducts business with, have competition based on price.
Open market operations can, on the one hand, be permanent and encompass the downright buying and selling of Treasury securities or government-sponsored enterprise debt securities. On the other hand, they can be temporary and encompass the buying of these securities under covenants to resell and the selling of these securities under covenants to repurchase. Significantly, OMOs have been employed in the past to make adjustments in the supply of reserve balances to maintain the federal funds rate close to the target federal funds rate (Federal Reserve, 2017).
2. Reserve Requirement
The reserve requirement alludes to the money that banks have to maintain overnight. Banks can maintain their reserves either within their respective vaults or with the Fed. On the one hand, a low reserve requirement enables banks to carry out greater lending of bank deposits and, in the long run, generates credit.
On the other hand, a high reserve requirement makes it more challenging for banks to lend out money. Conceivably, the most renowned tool is the feds funds rate. In this case, if a bank is unable to meet the reserve requirement, then it is conceivable to borrow funds from a different bank that currently has excess cash. The rate of interest paid is the feds funds rate Federal Reserve, 2017).
For example, at the culmination of the 2013 fiscal year, the central bank necessitated banking institutions to maintain reserves equivalent to zero percent of the initial $13.3 million in the bank deposits. Secondly, the banks were necessitated by the Fed to maintain reserves equivalent to 3 percent of the bank deposits up until $89 million regarding the checking and savings account. Lastly, there was a requirement of holding 10 percent of any banking deposit amount that surpasses $89 million.
Notably, there are very minimal or negligible changes that are made to...…by the Federal Reserve is open market operations. It is imperative to note that open market operations are the most flexible monetary tool, and as a result, most often employed by the Fed in its conduct of monetary policy. Open market operations are conducted by the Domestic Trading Desk of the Federal Reserve Bank of New York with such directives being handed out by the Federal Open Market Committee (FOMC). Notably, these transactions are carried out with primary dealers (Federal Reserve Education, n.d). There are numerous ways in which the central bank can carry out OMOs.
Nonetheless, for the most part, OMOs are carried out through the purchasing and selling of government securities to influence the number of bank reserves. Significantly, this takes into account the purchasing and selling of government securities in the secondary market. This implies that the Fed is not directly purchasing government securities from the government itself. Rather, the buying and selling of the securities are done with a private entity (Brandl, 2020).
Moreover, following Federal Reserve Education (n.d), the Fed regularly carries out open market operations numerous times in a week. The huge majority of open market operations are not designed to carry out alterations in monetary policy. In its place, open market operations are carried out on an everyday basis to preclude technical, transitory forces from pushing the effective federal funds rate exceedingly far from the target rate.
References…
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