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The Many Roles of the Fed: A Little More About the FOMC
How the Fed Guides Monetary Policy
The Fed's monetary policy actions affect prices, employment, and economic growth by influencing the availability and cost of money and
credit in the economy. This in turn influences consumers' and businesses' willingness to spend money on goods and services.
The Fed uses three monetary policy tools to influence the availability and cost of money and credit: open market operations, the discount
rate, and reserve requirements.
Open Market Operations
The Fed's most flexible and often-used tool of monetary policy is its open market operations for buying or selling government securities.
The Federal Open Market Committee (FOMC) sets the Fed's monetary policy, which is carried out through the trading desk of the Federal
Reserve Bank of New York. If the FOMC decides that more money and credit should be available, it directs the trading desk in New York
to buy securities from the open market.
The Fed pays for these securities by crediting the reserve accounts of banks involved with the sale. With more money in these reserve
accounts, banks have more money to lend, interest rates may fall, and consumer and business spending may increase, encouraging economic
expansion.
To tighten money and credit in the economy, the FOMC directs the New York trading desk to sell government securities, collecting payments
from banks by reducing their reserve accounts. With less money in these reserve accounts, banks have less money to lend, interest rates
may increase, consumer and business spending may decrease, and economic activity may slow down.
The Discount Rate
The discount rate is the interest rate a Reserve Bank charges eligible financial institutions to borrow funds on a short-term basis.
Unlike open market operations, which interact with financial market forces to influence short-term interest rates, the discount rate
is set by the boards of directors of the Federal Reserve Banks, and it is subject to approval by the Board of Governors. Under some
circumstances, changes in the discount rate can affect other open market interest rates in the economy. Changes in the discount rate
also can have an announcement effect, causing financial markets to respond to a potential change in the direction of monetary policy.
A higher discount rate can indicate a more restrictive policy, while a lower rate may be used to signal a more expansive policy.
Reserve Requirements
By law, financial institutions, whether or not they are members of the Federal Reserve System, must set aside a percentage of their deposits
as reserves to be held either as cash on hand or as reserve account balances at a Reserve Bank. The Federal Reserve sets reserve requirements
for all commercial banks, savings banks, savings and loans, credit unions, and U.S. branches and agencies of foreign banks. Depository
institutions use their reserve accounts at Federal Reserve Banks not only to satisfy reserve requirements, but also to process many financial
transactions through the Federal Reserve, such as check and electronic payments and currency and coin services.
Altering reserve requirements is rarely used as a monetary policy tool. However, reserve requirements support the implementation of
monetary policy by providing a more predictable demand for bank reserves, which increases the Fed's influence over short-term interest
rate changes when implementing open market operations.
The Many Roles of the Fed: A Little More About the FOMC
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