The Federal Reserve uses three main tools of monetary policy: open market operations, the reserve ratio, and the discount rate. Open market operations, where the Fed buys and sells Treasury securities, is the most important as it allows the Fed to flexibly manipulate bank reserves and money supply. Changing the reserve ratio is rarely used due to its powerful impact. The discount rate has little direct effect on money supply. By expanding or reducing bank reserves through open market operations, the Fed implements expansionary or contractionary monetary policy.

1. THE FEDERAL RESERVE:
Monetary Policy
MODULE 27

2. OBJECTIVES OF
MONETARY POLICY
A. The Fed’s Board of Governors formulates
policy, and the twelve Federal Reserve
Banks implement policy.
B. The fundamental objective of monetary
policy is to aid the economy in achieving
full-employment output with stable prices.
1. To do this, the Fed changes the nation’s
money supply.
2. To change money supply, the Fed
manipulates size of excess reserves held
by banks.

3. CONSOLIDATED BALANCE SHEET
OF THE FEDERAL RESERVE BANKS
A. The Fed’s balance sheet contains two major assets:
1. Securities which are Treasury Bills (bonds) purchased
by the Fed from commercial banks, and
2. Loans to banks.
B. The balance sheet contains three major liabilities:
1. Reserves of banks held as deposits at Federal Reserve
Banks,
2. US Treasury deposits of tax receipts and borrowed
funds, and
3. Federal Reserve Notes outstanding, the paper
currency.

4. THREE MAJOR “TOOLS” OF
MONETARY POLICY
1. Open market operations,
2. The reserve ratio, and
3. The discount rate.

5. OPEN MARKET OPERATIONS
A. Open-market operations refer to the buying and selling
of Treasury bills (or bonds).
1. Buying securities will increase bank reserves.
a. If the Fed buys directly from banks, then bank reserves
will go up by the price of the securities sold to the Fed.
b. If the Fed buys from the general public, people will
receive a check from the Fed when they sell the
securities to the Fed, then they will deposit this check at
their bank. Checkable deposits will rise and therefore
bank reserves by the same amount.
(i) Bank’s lending potential rises with new reserves.
(ii) Money supply rises directly with increased deposits by
the public.

6. OPEN MARKET OPERATIONS
c. Conclusion: When the Fed buys securities, bank
reserves will increase and the money supply potentially
can rise by a multiple of these reserves.
d. Note: When the Fed sells securities, bank reserves will
decrease, and eventually the money supply will go
down by a multiple of the bank’s decrease in reserves.

7. HOW DOES THE FED BET PEOPLE OR
BANKS TO BUY OR SELL BONDS?
1. When the Fed buys, it raises demand and price of the
Treasury Bills, which in turn lowers effective interest
rate on the bonds. The higher price and lower interest
rates make selling bonds to the Fed attractive.
2. When the Fed sells, the bond supply increases and the
bond prices fall, which raises the effective interest rate
yield on the bonds. The lower price and higher interest
rates make buying bonds from the Fed attractive.

8. THE RESERVE RATIO
A. The reserve ratio is the percentage of reserves required
for banks to back up their customer deposits.
1. Raising the reserve ratio increases required reserves
and shrinks excess reserves. Loss of excess reserves
shrinks banks’ lending ability and, therefore, the
potential money supply by a multiple amount of the
change in excess reserves.
2. Lowering the reserve ratio decreases the required
reserves and expands excess reserves. Gain in excess
reserves increases banks’ lending ability and, therefore,
the potential money supply by a multiple amount of the
increase in excess reserves.

9. THE RESERVE RATIO
3. Changing the reserve ratio has two
effects:
(i) It affects the size of excess reserves,
and
(ii) It changes the size of the monetary
multiplier.
4. Changing the reserve ratio is very
powerful and could create instability, so the
Fed rarely changes it. The last time it was
changed was in February 1992, when the
ratio was lowered from 12 percent of
demand deposits to 10 percent, at which
level it continues.

10. THE DISCOUNT RATE
A. The discount rate is the interest rate that
the Fed charges financial institutions that
borrow from the Fed.
1. An increase in the discount rate signals
that borrowing reserves is more difficult
and will tend to shrink excess reserves.
2. A decrease in the discount rate signals
that borrowing reserves will be easier
and will tend to expand excess reserves.

11. MONETARY POLICY
“Easy” monetary policy occurs when the
Fed tries to increase the money supply by
expanding excess reserves in order to
stimulate the economy (expansionary
policy). The Fed will enact one or more of
the following measures:
1. The Fed will buy Treasury Bills,
2. The Fed may reduce the reserve ratio
(although this is rare because of its
powerful impact), or
3. The Fed could reduce the discount rate
(although this has little direct impact on
the money supply).

12. MONETARY POLICY
“Tight” monetary policy occurs when the
Fed tries to decrease money supply by
decreasing excess reserves in order to slow
spending in the economy during an
inflationary period (contractionary policy.
The Fed will enact one or more of the
following policies:
1. The Fed will sell Treasury Bills,
2. The Fed may raise the reserve ratio
(although this is rare because of its
powerful impact), or
3. The Fed could raise the discount rate
(although this has little direct impact on
the money supply).

13. OPEN MARKET OPERATIONS ARE THE
FED’S MOST IMPORTANT CONTROL
1. Changing the discount rate has little
direct effect on the money supply, since
only 2-3 percent of bank reserves are
borrowed from the Fed.
2. The Fed can manipulate reserves by
buying and selling Treasury Bills directly
and frequently.
3. Open-market operations are flexible
because securities can be bought or
sold quickly and in great quantities.