SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 8)

The Fed's Major Policy Tools

by

Charles Lamson

When someone is suffering from a back ailment, physicians usually have several therapeutic approaches available, including rest, traction braces, muscle relaxers, and surgery. These "tools," which can be used in combination, are all designed to relieve pain and restore the patient's health. Since policy makers are similarly equipped and motivated. let us examine the Fed's major policy tools

Open Market Operations

Open market operations are the most important monetary policy tool at the Fed's disposal. These operations which are executed by the Federal Reserve Bank of New York, under the guidance and direction of the FOMC, involve the buying or selling of U.S. government securities by the Fed. When the Fed buys securities, reserves fall. These operations are important because they have a direct effect on the reserves that are available to depository institutions. Depository institutions are required to hold reserve assets equal to a certain proportion of outstanding deposit liabilities. Changes in reserves, in turn, affect the ability of depository institutions to make loans and to extend credit. When banks or other depository institutions to make loans, they create checkable deposits. Thus, changes in reserves also affect the money supply. Consequently, when reserves change, the money supply and credit extension also change.

The Discount Rate and Discount Rate Policy

Because the Fed controls the amount of required reserve assets that depository institutions must hold, it also operates a lending facility called the discount window, through which depository institutions, caught short of reserves, can borrow from the Fed. The discount rate is the interest rate the Fed charges depository institutions that borrow reserves directly from the Fed. The discount rate is a highly visible, but less important, Fed policy tool. We say that it is "visible" because changes in the discount rate are often well-publicized, for example, on the evening news broadcast. 

Reserve Requirements

The major item on the liability side of depository institutions' balance sheets is deposits. The Fed requires depository institutions to hold required reserves equal to a proportion of the checkable deposit liabilities. The Fed specifies the required reserve ratio, which is the fraction that must be held. For example, if the required reserve ratio on checkable deposits is 10 percent, then for each $1.00 in checkable deposit liabilities outstanding, a depository must hold $.10 in reserve assets.

Recap

The Fed's main tools for implementing monetary policy are open market operations and setting the required reserve ratio and the discount rate. Open market operations are the most widely used tool.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD EDITION, 2003,  MAUREEN BURTON & RAY LOMBRA, PGS. 90-94

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