The Federal Reserve

The Federal Reserve

The Federal Reserve (The Fed) uses monetary policy to promote a well- functioning economy. The Fed has four main goals when considering which policy target to use. Those four goals are price stability, high employment, stability of financial markets and institutions, and economic growth.

The Fed uses a contractionary monetary policy or an expansionary monetary policy. An expansionary monetary policy increases the quantity of money that is in circulation with corresponding reductions in interest rates. It is used for the expressed purpose of stimulating the economy and to address the problem of high unemployment. The primary monetary policy tool used by the Fed is Open Market Operations. This tool is used primarily because it is flexible, easily implemented, and quite effective.

Open Market Operations are the buying and selling of U.S. Treasury securities to control bank reserves, increase or decrease money supply, and control interest rates. The Fed uses a branch of The Federal Reserve Board called The Federal Open Market Committee (FOMC) that is responsible for Open Market Operations. The FOMC meets eight times a year in Washington, D.C. to set interest rates and control the money supply. The FOMC buys or sells the U.S. Treasury securities. The FOMC consists of the Board of Governors, which has seven members, and five reserve bank presidents. The FOMC meets to determine if there is a need to increase or decrease the money supply, depending on the state of the economy.

Open Market Operations is not the only policy tool that the Fed has available. The Fed also uses discount or fund rate, which is the interest rate the Fed charges on discount loans made to banks. Reserve Requirements are also used. Reserve Requirements are the amount of funds that a banking institution must hold against specified deposit liabilities. The banks must hold the reserves in vault cash or deposits with the Federal Reserve Banks.

The Open Market Operations is effective in stimulating the economy because it lowers interest rates, making it appealing for firms to take out loans to upgrade equipment or software which increase production. The increase in production leads to higher employment rates and effectively lowering the unemployment rate. This provides people with enough disposable income to spend on their various wants and needs.

The Fed may also use contractionary monetary policy to address inflation.