Aside from market dynamics like consumer spending and business investment decisions, a major influence on a country’s economic performance is public policy—particularly fiscal policy and monetary policy. Fiscal policy is determined by the legislative and executive branches of the U.S. government chiefly through decisions about taxation and spending. Monetary policy is carried out by the Federal Reserve.

The objectives of the nation’s economic policy are to protect the purchasing power of the U.S. dollar, encourage conditions that sustain economic growth and a high level of employment, and foster a reasonable balance in transactions with other nations over the long run. The Federal Reserve contributes to these objectives through its monetary policy actions affecting the availability and cost of money and credit.

The Fed, seeking to adjust monetary policy to changing economic conditions, bases its policy decisions on current economic and financial information. For example, the FOMC’s policy actions are influenced at least in part by the economic analysis provided by staff economists and analysts at the Reserve Banks and the Board of Governors. Each component of the Fed—the Board of Governors, the Reserve Banks, and the FOMC—plays various roles in formulating and carrying out monetary policy.

Tools of Monetary Policy
To foster economic growth while maintaining stable prices, the Federal Reserve must balance the flow of money and credit with the needs of the economy. The Board of Governors, the Reserve Banks, and the FOMC achieve this balance by influencing the levels of financial institutions’ reserves, which in turn affect the institutions’ ability to make loans or purchase investments. These reserves, required by law of all U.S. depository institutions, must be equal to specified percentages of the institutions’ deposits and can be held either in the form of cash on hand or account balances at Reserve Banks.

The Fed has three policy tools for influencing reserves: open market operations, the discount rate, and reserve requirements.

Open market operations. The most flexible, and therefore most important, of the Fed’s monetary policy tools is open market operations—the purchase and sale of government securities in the open market. The Fed’s open market operations are directed by the FOMC and carried out through the trading desk of the Federal Reserve Bank of New York.

To increase the availability of money and credit, the Fed buys government securities. These purchases are paid for by crediting the reserve accounts (held at Reserve Banks) of the depository institutions handling the securities dealers’ transactions. These larger reserve accounts give the banks more money for lending and investing elsewhere.

To tighten money and credit flows the Fed sells securities, thereby restraining the growth in banks’ reserve balances and restricting their lending and investing activities.

The discount rate. Depository institutions sometimes borrow money from Reserve Banks to cover temporary deposit drains. The discount rate, the rate of interest charged on these short-term, “discount window” loans, is set by Reserve Banks’ boards of directors, subject to approval by the Board of Governors. A change in the discount rate can either inhibit or encourage financial institutions’ lending and investment activities by making it more or less expensive for them to obtain funds. Although the discount rate may have little direct effect on market conditions, a change in the discount rate can be an important signal of the Fed’s policy direction.

Reserve requirements. Within limits prescribed by law, the Board of Governors can change the percentage of deposits that depository institutions must set aside as reserves. The Federal Reserve changes reserve requirements much less often than it does the discount rate because such changes have a farther-reaching impact on the financial industry.

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