Lesson 6.5: How the Federal Reserve Implements Monetary Policy

Flashcards made from a presentation segment created as a lesson on the Federal Reserve's implementation of monetary policy.

Monetary policy

The actions of the Federal Reserve to manage the money supply and credit conditions to achieve sustainable economic growth

• This affects interest rates (the cost of borrowing money), which in turn can affect the level of spending and investment in the economy

• Must be carefully timed and planned for steady and sustainable pacing

Dual Mandate

The two duties of the Federal Reserve to promote maximum employment and price stability

Maximum employment

The highest level of employment that the economy can sustain while maintaining a stable inflation rate (generally considered to be 2%)

Price stability

A low and stable rate of inflation maintained over an extended period of time

Federal Open Market Committee (FOMC)

The group within the Federal Reserve System that conducts monetary policy

• 5 Reserve Bank Presidents and 7 Governors have voting rights while the rest are simply part of the committee

• Meets 8 times a year, 2 days at a time to assess appropriate monetary policy decisions

• Their set target rate goes on to affect the market, business, employment, and inflation later on

Reserve balance accounts

Where banks can hold cash at the Federal Reserve

• These are used for loans to other banks in a federal funds transaction

Federal funds transaction

The transfer of funds from one bank’s reserve account to another bank’s reserve account

Federal funds rate (FFR)

The interest rate agreed upon in a federal funds transaction between two banks

• Set by the Federal Reserve through a target level achieved with open market operations

• Helps influence rates in the economy as well as business and consumer decisions

Required reserve

The amount of money banks are required to keep in their deposits

• Lowering of this can increase the money supply and aid high unemployment

• Raising of this can reduce lending and aid high inflation

• Not often adjusted compared to other methods of administering monetary policy

Discount rate

The interest rate the Federal Reserve charges on loans to financial institutions

• Primarily used to ensure sufficient funds are available in the economy

• Set above the Federal Funds Rate

Prime rate

The rate of interest that banks charge on short-term loans to their best customers

• This is affected by the Federal Funds and discount rates

Open market operations

The buying and selling of government securities in order to alter the supply of money through transactions

• Is the most important and most often used tool employed by the Federal Reserve to implement monetary policy

Easy money policy

Policy that increases the money supply with lower interest rates to encourage investment spending

Tight money policy

Policy that decreases the money supply with higher interest rates, lowering investment spending to avoid high inflation

Inside lag

The time it takes to identify and implement a policy

• More severe for fiscal policy because it includes changes in taxes and spending, as monetary policy does not have to go through Congress and the President

Outside lag

The time it takes for a policy to have an effect

• More severe for monetary policy because it primarily affects business investment plans, which may not have a full effect on spending for several years

Keynesian economics

An economic school of thought that emphasizes fiscal policy over monetary policy, smoothing out the business cycle with government spending

Monetarism

An economic school of thought established by Milton Friedman that believes that the money supply is the most important factor in macroeconomics

Classical economics

An economic school of thought that believes in self-correction, recommending against new policies and arguing that governmental intervention disrupts the proper functioning of a free-market economy