Monetary policy consists of the steps the central bank of a nation can take in order to regulate the nation's money supply. For instance, a central bank might reduce interest rates during a recession in order to make loans more readily available to other banks and thus stimulate economic recovery.
In the United States, the central bank is actually a system of twelve banks known as the Federal Reserve System, or more simply, the Fed. As with any central bank, the main job of the Federal Reserve is to conduct monetary policy for the U.S. government - to regulate the economy by regulating the supply of money in circulation. There are three basic ways in which the Fed accomplishes this.
The primary method by which the Fed conducts monetary policy is through the buying and selling of government securities on the open market. This process, called open market operations, is conducted regularly by the Fed as a way to manipulate the money supply.
Eight times a year, the Federal Open Market Committee (FOMC) meets to review and discuss reports on previous and prospecive economic developments. After the reports, each committee member presents his or her views on the state of the economy and a recommendation on monetary policy for the period of time until the next FOMC meeting. Upon reaching a consensus on monetary policy, the FOMC directs the Federal Reserve Bank of New York on the execution of sales or purchases of government securities.
When the Fed buys securities on the open market, cash is transferred to these banks, increasing the nation’s money supply. Conversely, when the Fed sells government securities, these banks have less cash available to them – a decrease in the nation’s money supply. In this way, the Fed can achieve specific monetary policy goals with short-term, sometimes daily, transactions.
Because commercial banks keep reserve accounts with the Fed, either as actual deposits at a Federal Reserve bank or as “vault cash” at their own location, these transactions are made instantaneously and electonically. The amount of money kept in reserve by commercial banks is known as the reserve ratio and is another tool used by the Fed to implement monetary policy. The Fed may raise the amount of money banks are required to keep in reserve in order to decrease the money supply, or they may lower the requirement in order to make the banks more liquid and stimulate the economy. This mechanism is more drastic in its effect upon the commercial banks, and for this reason is used infrequently by the Fed.
Instead, the Fed may use interest rates, such as the discount rate and the federal funds rate, to encourage or discourage lending among banks. The discount rate is the interest rate the Fed charges on loans it makes to commercial banks. By reducing the discount rate, the Fed makes it more attractive for commercial banks to borrow money. As they do so, the nation's money supply increases and the economy expands. Similarly, commercial banks that keep monetary reserves with the Fed can loan this money, these federal funds, to each other. These loans are made at the Federal Funds Rate, another rate that the Fed has the power to raise or lower in order to impact the money supply.