For monetary policy, the Fed mostly uses
various types monetary policy instruments especially the discount rate, reserve
requirements like CRR and SLR, open market operations, repo and reserve repo
rates and margin requirements. Such policies regulate the money in the banking
system and with money multiplier control the amount of currency available with
the public along with regulation of the forex reserves to regulate the imports
and stability of the dollar (Woodford, 2011).
Some of the policies are encompassed as below:
on the Reserves: It was
one of the latest tool used by the Fed by the Congress especially after the
Financial Crisis of 2007-2009. It is basically the interest paid by the Reserve
Banks on the amount deposited by the banks with the reserve. It hugely
influences lending operations of the bank. For example, if the Fed wants the
bank to lend more currency out to the public to increase the money supply, it
might decrease the interest rate it pays to hold the reserves and vice versa.
Discount rate: Interest charged by Reserve banks on short
term loans taken by commercial banks. Lending by Fed serves as a backup for
liquidity for banks. Lower discount rates encourages spending and higher
discount rates encourages savings.
Reserve requirements: Amount hold by banks either as vault cash or
with deposits with the Reserve Bank. A decrease leads to more funds available
with the bank to lend to the public and an increase means less money available
to the bank to lend to public hence controlling inflation.
Open market operations: this involves lending/borrowing
by the Government and is the most used monetary policy. The Government borrows
from the public via sale of treasury bills to fund its deficit budget and
control the inflation as well as forex reserves.
Why the Fed does not use discount rate as a
The procedure for the discount rate is as
follows: the banks borrow short term money from the Fed to satisfy immediate
requirements. They have to provide a collateral generally in the form of U.S
Treasury Bills, notes, Commercial Deposits, mortgage- backed securities etc. to
borrow money from the Fed. The Fed generally charges the Fed interest rate
which is 0.5% higher than the overnight borrowing rate as it prefers bank to
borrow from each other rather than relying on the Fed to provide money. It is a
negative sign that the bank cannot get loans from other banks and has to borrow
from Fed. This will make other banks slightly disapproving while lending money
in the future. It uses the discount window as the last resort to influence
economy in two ways: first by raising the discount rate to reduce money supply (contractionary
monetary policy) and second by decreasing the discount rate to increase money
in the economy (expansionary monetary policy) to stimulate growth (Mayer, 1968).
tool is most used by Fed for effective monetary policy?
Fed generally uses the open market
operations as an effective monetary policy tools. Using the market, the Fed
usually sells or buys Government securities to regulate the money supply in the
market. It is one of the best tools to control inflation and also balance of
payments. Whenever the money supply in the market rises, the Fed issues T-bills
to raise money from the public hence decreasing the money available with the
public. The government can then use the money to fund capital receipts to
promote growth in the economy. Also, it can use the money to fund the deficit
expenditure (Odell, 2014). When the money supply in the market decreases, the
Fed can buy back such securities from the market, infusing more money into the
economy and the consumption of the public will increase reading to more
aggregate demand and hence growth. During balance of payment crisis, Fed can
sell/buy currency of other countries, thus regulating the price of the dollar
and keeping it stable.