• Open Market Operations
• Reserve Requirements
• Discount Window Lending

The Fed has three monetary policy tools—open market operations, reserve requirements and discount window lending.

Open market operations are the most important and active tool of monetary policy that the Fed uses. These operations consist of the Fed buying and selling previously issued U.S. government securities, or IOUs of the federal government.

The Fed adds extra credit to the banking system when it buys Treasury securities from the dealers, and drains credit when it sells to the dealers. As the laws of supply and demand take over in the reserves market, the cost of funds for the remaining reserves finds its level at the federal funds rate.

The federal funds rate is the interest rate banks charge each other for overnight loans.

The Fed’s open market operations are conducted in the following manner:

Interest rates affect the level of activity in the economy. When rates are low, people find it easier to buy cars and homes, and businesses are more inclined to invest in new machinery and buildings. And when the rates are high the opposite occurs as the Fed tries to curtail inflation and maintain economic growth.

Open market operations typically are conducted several times a week. A majority of the open market operations are not intended to carry out changes in monetary policy. Rather, they are conducted to prevent some technical, temporary forces from pushing money and credit conditions in some undesired direction.

The public’s demand for cash varies, depending on the season, the day of the month and even the day of the week. When people hold more cash, the reserves of the bank go down. And that could push short-term interest rates up, if the Fed did not use open market operations to offset the increase.

The Fed has to be watchful, not only for any signs of impending inflation or recession, but also for how technical factors may be affecting the supply of money and credit in the economy.

Reserve requirements are the percentages of certain types of deposits that banks must keep on hand in their own vaults or on deposit at a Federal Reserve Bank. The Fed has the authority to set reserve requirements on checking accounts and certain types of savings accounts.

The Fed rarely changes the reserve requirements. The last change made to the reserve requirement was in April 1992, when they lowered the rate from 12% to 10% of transaction deposits.

Changes in the reserve requirement make planning difficult for lenders, and any increase imposes a cost on them. The Fed generally does not change the reserve requirement when there is an alternative way of achieving the same policy result.

Discount rate, another tool of monetary policy, is the interest rate that the Fed charges banks for short-term loans. Changes in the discount rate typically occur in conjunction with changes in the federal funds rate.

Through the discount window, Federal Reserve Banks lend funds to depository institutions. All depository institutions that maintain transaction accounts or non-personal time deposits subject to reserve requirements are entitled to borrow at the discount window.

Increases in the discount rate generally reflect the Federal Reserve's concern over inflationary pressures, while decreases often reflect a concern over economic weakness.

October 2007