The Federal Reserve which is also known as the Federal Reserve System or the Fed is the central banking system that is used to manage the financial and banking system in the United States. The reserve was established in 1913 to respond to the financial panic that had affected many banks and financial institutions in the country during 1907. The US Congress enacted the Federal Reserve Act in 1913 to respond to this crisis where the reserve requirements for commercial banks within the United States stipulated that they had to be members of the Federal Reserve System.
The act also stipulated that a Federal Reserve Bank had to be established in 12 districts within the United States as well as cities within these districts to manage the financial aspects of the American states. These federal banks were meant to monitor and control the supply of money to the various commercial banks within the 12 districts (Madura 74).
The main role of the Federal Reserve during its establishment was to maintain the stability of the American financial system as well as provide financial services to depository institutions such as the US government and other foreign official organizations within the country. The functions and errands of the US Federal System have with time continued to increase and change as the organization of The Fed continues to change.
The main duties of the bank in the current context include implementing and overseeing the American monetary policy and supervising and regulating banking institutions within the country, adjusting the money supply of commercial banks within America, regulating the supply of money to maintain full employment within the country as well as ensure that there is low or zero inflation in the country (Madura 75).
The purpose of this essay will be to discuss the three tools of monetary policy that the Federal Reserve uses to influence the amount of money held in reserve in most of the private banks within the US. The first monetary tool that is used by the Federal Reserve is the open market operations tool which is mostly used for the purchase and sale of US Treasury bills, government and federal agency securities in the public market.
This is the main tool that is used by the Federal Reserve in implementing monetary policy where the primary focus of this tool is on attaining a specified level of federal funds rates used by commercial banks in the United States for overnight loans. The open market operations monetary tool is also the most commonly used as it changes the excess reserves that exist in the financial depository institutions of the banking sector in the US. While it is the most commonly used policy, its processes are complex and difficult to understand because of the detailed procedures that are involved in this tool (Mandura 78).
The buying and selling of US government securities and Treasury bills is conducted in the Federal Reserve Bank of New York and these buying and/or selling is done in every business day of the week meaning that federal adjustments can be made quickly with regards to the situation in the open market. The open market operations is a powerful tool in enacting monetary policies as it allows for changes in the Federal Reserve as operations under this tool are conducted on every business day. The open market operations are also the primary tool of monetary policy in the Federal Reserve as they allow for the alteration of quantity reserves depending on whether US government securities have been bought or sold in the open market in either large or small quantities (Madura 81).
The second tool used by the Federal Reserve to enact monetary policy is the preserve necessities financial tool which is the sum of funds that a reservoir establishment such as a commercial bank should hold in store against the particular deposit dangers. All depository institutions within the United States are subject to the reserve requirement ratio which is amount of deposit accounts that these institutions must hold as reserves.
The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) enacted by the US Congress in 1980 was formulated to ensure that all institutions involved in depository and financial activities were subject to the reserve requirements imposed by the Federal Reserve System. The reserve requirement ratio that is currently used by most commercial banks in the US is 8% to 12% of their account transactions (Madura 82).
Both Federal Reserve requirements and the requirement ratio affect the degree to which money supply within depository institutions will change. The Board of Governors usually adjusts the supply of money depending on the increase or decrease of a bank’s deposits. In the event the board reduces the reserve requirement ratio, the proportion of bank deposits and loans lent out by depository institutions will increase. This means that the lower the reserve requirement ration, the higher will be the lending capacity of depository institutions causing a change in the money supply within the Federal Reserve Banks.
Any adjustment to the reserve requirement ration changes the proportion of funds or loans that can be lent out to other institutions within the US. The Federal Reserve is usually not involved in the radical change of reserve requirements when implementing monetary policies in depository institutions. The Board of Governors is usually charged with the role of maintaining money supply within the depository institutions in the country. The Board ensures that the reserve requirements prevent any excessive removal of funds by depository institutions that might cause a shock in the country’s depository systems (Madura 82).
The third policy tool that is used by the Federal Reserve is the discount rate which is the lending facility or discount window used by the Federal Reserve Bank. The discount rate operates under the assumption that all depository institutions borrow financial reserves from a Federal Reserve Bank located in any of the 12 districts of the United States. When these institutions borrow money from these federal banks, their reserve accounts usually increase and they decrease once they repay these funds to the reserve system. The discount rate is an interest rate charged to these depository institutions for borrowing reserves from a Federal Reserve Bank.
Any increases to these discount rates are usually used by the Federal Reserve to discourage reserve borrowing by depository institutions while a decrease of these rates is usually used to encourage borrowing in these institutions (Madura 83).
The three discount rates that are offered by the Federal Reserve include primary credit, secondary credit and seasonal credit. Each of these discount windows have their own interest rates which are usually determined by the type of depository institution borrowing the funds and also the amount of money borrowed by these institutions. The reserve’s lending facility which is known as the discount window ensures that all loans borrowed from the depository institutions are fully secured.
In the primary credit discount program, loans are extended for a very short period while in the secondary credit; institutions that are not qualified for primary credit qualify for this type of discount. In the seasonal credit, this type of discount rate is extended to small depository institutions that have recurring funding needs. The type of policy that is currently in place to govern the functions of the discount rate is to charge depository institutions both large and small in the United States based on the loans they receive from the regional Federal Reserve Banks (Madura 83).
Works Cited
Madura, Jeff. Financial markets and institutions. Mason, Ohio: Thomson Higher Education, 2008. Print.