The Federal Reserve System (Fed) through the Federal Open Market Committee (FOMC) managers the monetary policy of the US by using interest rate in indirectly controlling inflation and indirectly influencing output and employment (Federal Reserve Bank of San Francisco, 2009a, 2009b). This paper seeks to explain further this assertion in understanding the how the Fed function in relation to interest rates, and monetary policy.
2. Analysis and Discussion
2.1. How does the Fed use the monetary policy to accomplish its purpose?
Monetary policy aims to attain economic objectives by promoting sustainable output in its “maximum” and in promoting stable prices as provided for in the 1977 amendment of the Federal Reserve Act (Federal Reserve Bank of San Francisco, 2009c). Thus, the Fed uses monetary policy tools to indirectly control inflation and indirectly influence output and employment.
Fed used accomplish this mainly by raising or lowering short-term interest rate called “federal funds” rate via the open market operations in the market for bank reserves, known as federal funds market. In theory and in practice, US banks and other depository institutions (or “banks”) are required to have reserves by the Fed to keep a certain amount of funds in reserved to meet unexpected outflows. In practice however, banks normally hold even more than they are required to in order to have extra funds in clearing overnight checks and in making other payments. Banks have the option of keeping these reserves as deposits with the Fed or in cash in their vaults (Federal Reserve Bank of San Francisco, 2009a).
On a daily basis, the amount of bank reserves kept varies depending on bank deposits and bank transactions and sometimes a bank needs additional reserves on a short-term basis. The remedy of the latter would be to borrow from other banks that happen to have more reserves than they need. The loans taking place within the banks as they borrow from each other is called the federal funds market which cost the so called “funds rate” or interest rate on the overnight borrowing of reserves. The said rate therefore adjusts to balance the supply of demand and demand for reserves, so that excess supply of reserves over demand causes fall in rate and the reverse would cause rise in funds rate.
By open market operations, the Fed through the Federal Reserve Bank of New York uses the tool to affect the supply of reserves in the banking system by buying and selling government securities on the open market. In desiring to have the funds rate to fall, the Fed simply buys government securities from a bank and then pays for the securities for by increasing the bank’s reserves. This would produce more bank reserves for the bank which sold to the Fed which would given to said bank the option lend these unwanted reserves to another bank in the federal funds market.
It is therefore easy to appreciate how the Fed’s open market purchase of government securities could increase the supply of reserves to the banking system while allowing the federal funds rate to fall. It must be remembered that the Fed has the capacity to acquired very big government securities since the literally it can do so very powerfully as way to influence money supply in the system in relation to its function of indirectly controlling inflation or deflation.
The other side of the Fed’s power in its capacity to increase the funds rate when it wants to by this time selling government securities where payments would also be received via reserves from the banks. This latter act would have the effect of lowering the supply of reserves in the banking system as the funds rate increases because of tighter monetary supply.
In relation to the Fed’s monetary-policy use of interest rate, the Fed also makes use of the discount rates where banks can also borrow reserves directly from the Federal Reserve Banks where the discount rate would be equivalent to the what financially sound banks must pay for the called primary credit. As the Board of Directors of the Reserve Banks set these rates, subject to the review and determination of the Federal Reserve Board, the said discount rate is normally set higher than the funds rate to allow first the banks to exhaust the less expensive alternative before turning to this source (Federal Reserve Bank of San Francisco, 2009a).