The Fed is the popular informal reference to the Federal Reserve System, which is the Central Banking System of the U S. with the endorsement of the Federal Reserve Act in 1931, the fed was established (Federal Reserve System Online, 2008). The Federal Reserve System is a government banking institution with supporting constituents that are privately owned. It is made up of the Board of Governors of the Fed appointed by the President, the Federal Open Market Committee, twelve Federal Reserve Banks found in some main cities in the US, various privately owned banks in the US which are members of the fed and also several advisory councils (Wikipedia, 2008).
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An amendment to the Federal Act in 1977 set out the main goals of monetary policy as promotion of the highest maintainable output and employment and also the promotion of stable prices in the economy (Federal Reserve Bank of San Francisco, 2007). The sustainable output and employment should be at a level that is in tandem with the other parameters of the economy which influence the levels of employment like technology, the choice to save risk, and effort put into work.
Since the economy usually undergoes business cycles, in which output and employment will be higher than or lower than their desired long-run levels, then monetary policy will be vital in stimulating the economy in the short run to put it on the path for long-run output levels by reducing the interest rates…(Federal Reserve Bank of San Francisco, 2007).
The fed controls the money supply in the economy of the US by keeping control of the loans which are given by the commercial banks using their excess reserves. So to control money supply the fed will have to control the reserves through changing the required reserve ratio, varying the discount rate, and using open market operations (Econ Explorer, 2008).
If the Fed is to use the required reserve ratio, it would reduce the required ratio and the effect is that the commercial banks will have more excess reserves to loan out to the public thus the money supply in the economy will be increased. To reduce the money supply the required reserve ratio will be increased. When the fed increases the discount rate for lending out to the commercial banks, they will be discouraged from borrowing and their lending rates to the public will also be high so the public will borrow less and the money supply in the economy will be reduced. If the rate is decreased, the reverse will be achieved. For the open market operations, the fed can either sell or purchase the treasury securities to either increase or reduce the money supply in the economy. When the fed wants to increase the money supply in the economy, it will purchase the treasury securities, and to reduce the money supply it will sell the securities.
Various monetary policy tools can be used by the fed to achieve its desired policy objectives. These objectives are often dependant on the state of the economy and what the fed would want to attain in the economy. Some of the monetary policy tools available to the fed are interested in required reserves, term auction facility, primary dealer credit facility, term securities lending facility, ABCP MMMF Lending facility, Commercial Paper Funding Facility, Money Market Investor Funding Facility, and the Term Asset-Backed Securities Loan Facility (FRB Monetary Policy, 2008) The policy tools that will be elaborated on in this paper are Open Market Operations, The Discount Rate, and The Reserve Requirements.
- Open Market Operations.
These are the main tools for executing monetary policies and the goals for its use are set by the Federal Open Market Committee. (Federal Reserve Board, 2008). When the Fed uses the OMO, it can either buy or sell the US Treasury and federal agency securities to have a preferred price, i.e. the federal funds rate, price stability, and maintainable growth in the economy.
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- The Discount Rate.
This is the interest rate at which the commercial banks and the other deposit-taking financial institutions are charged for the loans they take from their local Federal Reserve Bank’s loaning systems ie the discount windows which can be primary, secondary, or seasonal credit. (Federal Reserve Board, 2008)
- Reserve Requirements.
These are the minimum quantity of finances which a deposit-taking financial institution is required to keep in reserve against some predetermined deposit liabilities. The reserve requirements are determined by the Board of governors.
Of late there has been a financial crisis in the US economy and therefore the fed has been busy executing various monetary policy instruments at its disposal in a bid to increase liquidity in the markets. In this respect it has been extending the liquidity facilities it uses which are aimed at providing discount window loans to primary dealers, loaning out to deposit-taking financial institutions to be able to buy the asset-backed commercial papers from the money market mutual funds, and also providing of liquidity to the money market investors in the united states. These are done to relieve the strains in the financial markets in the United States (Fed Press Release, 2008).
- Econ Explorer. 2008. How Is the Supply of Money Controlled? Web.
- Federal Reserve System. Web.
- Federal Reserve Bank of San Francisco. 2007. About the Fed. Goals of Monetary Policy. Web.
- Federal Reserve System Online. Unique Structure. Web.
- The Federal Reserve Board. The Structure of The Federal Reserve System. Web.
- The Federal Reserve Board. Open Market Operations. Web.
- Wikipedia. 2008. Federal Reserve System. Web.