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Monetary policy

Monetary policy is conducted by the Federal Reserve and consists of changes in the money supply to change the level of spending in the economy.

Expanded Definition

The goal with monetary policy is to accomplish manageable inflation, full employment, and steady growth in the economy. The 12 Federal Reserve Banks are responsible for conducting monetary policy and are referred to as the U.S. central bank. The Federal Reserve Banks' balance sheet reveals to us how these 12 banks are conducting monetary policy.

The asset side of the balance sheet consists of securities and loans to commercial banks. The liability side consists of reserves of commercial banks, treasury deposits, and federal reserve notes outstanding.

The Federal Reserve has three main tools at its disposal to manage the money supply: open-market operations, the discount rate, and the reserve ratio.

Open-market Operations

Open-market operations are the Federal Reserve's most important tool in changing the money supply. Through these operations, the Fed buys government bonds from commercial banks and the public. When the Fed purchases government bonds from commercial banks, the commercial banks give up some of their assets (securities) to the Federal Reserve. Also, by buying from commercial banks, the Fed increases the reserves of the commercial banks. Banks are able to lend money by holding large reserves. After buying bonds from banks, the banks' balance sheet has more capacity to lend because their assets have shifted from securities to reserves.

The same effect occurs when the Fed buys bonds from the public (small businesses and local banks). When the Fed purchases bonds from the public, these small businesses and local banks are left with more cash in reserves and less of their assets sitting in securities. Therefore, businesses and local banks are able to increase their checkable deposits from the cash the Fed paid for their securities.

The chain reaction of open-market operations works like this. The small business receives cash for their bonds, they deposit the cash in the bank which increases the bank's checkable deposits and reserves. These extra reserves allow the bank to make more loans and, in turn, increase the money supply.

The opposite effect happens when the Federal Reserve sells securities to the commercial banks and the public. Securities are increased on the balance sheets of businesses and banks, which decrease reserves and cash accounts, decreasing the money supply.

The Reserve Ratio

A second tool for the Federal Reserve is the reserve ratio. The Fed uses this tool very rarely, but when used the reserve ratio is a very good tool to control the creation of money. If a bank has $1 billion in checkable deposits and the reserve ratio is set at 20 percent, then the bank must hold at least $200 million in reserves. A bank can only lend what it has in excess reserves. So, if the bank has $300 million in reserves, then it has $100 million of excess reserves which the bank can use to make loans. If the Fed increases the reserve ratio to 30 percent, then the bank must hold in $300 million in reserves and, therefore, will have zero excess reserves to make loans. The Fed can also take reserve ratio down to allow banks to increase their excess reserves and the money supply.

The Discount Rate

The third, and probably more common, tool for the Federal Reserve is the discount rate. The discount rate is the interest rate charged to commercial banks on loans from the Federal Reserve. These loans from the Fed to commercial banks shows up on the Fed's balance sheet as a Federal Reserve promissory note (IOU). There are no reserve requirements for loans to commercial banks and, consequently, these loans are immediately added to banks' excess reserves.

When the Fed increases the discount rate, it is making it more expensive for commercial banks to borrow money from the Fed; therefore, the commercial banks will be less likely to borrow and add to their ability to increase the money supply from additional excess reserves. The opposite scenario happens when the Fed lowers the discount rate. Commercial banks are more likely to borrow and increase their excess reserves to make more loans, which increases the money supply.

When the Federal Reserve buys securities, lowers the discount rate, and/or lowers the reserve ratio, economists call this an easy money policy. When the discount rate is increased, sells securities, and/or increases the reserve ratio, it is called a tight money policy.

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