In the US, the Federal Reserve uses five different types of monetary policy. The five types of monetary policy are bank reserve requirements, the federal funds market, open market operations, the discount rate, foreign currency operations. The Federal Reserve uses these types of monetary policy to control the economic conditions in the country. Other countries may use a mix of policies that are similar, depending on their type of economy.
The first of the types of monetary policy is the set of bank reserve requirements that the Federal Reserve requires banks to hold. The bank reserve is a minimum amount of money that the bank is required to keep in the bank’s account. This is money that cannot be given out to customers as loans or used for other purposes. When the Federal Reserve wants to stimulate the economy, it lowers the bank reserve requirement. When the Federal Reserve wants to institute a more restrictive monetary policy, it increases the bank reserve requirement.
The federal funds market is the short term lending market between banks. In fact, it is only an overnight loan. When the Federal Reserve wants to discourage this lending and borrowing, it will increase the interest rate in the federal funds market. When it wants to increase this type of lending, the Federal Reserve will decrease the lending interest rate.
One of the other types of monetary policy tools the Federal Reserve uses is open market operations. Open market operations is the market in which the Federal Government sells or buys government securities, such as US Treasuries. The Federal Reserve will buy government securities when it wants to decrease the interest rate in the open market. It sells securities when it wants to increase the interest rate.
When banks in the Federal Reserve borrow money directly from the reserve, it lends this money at the discount rate. When the Federal Reserve wants to discourage banks from borrowing money from it, it increases the interest rate. When it wants to encourage the banks to borrow money from the Federal Reserve, the Fed decreases the discount rate.
The Federal Reserve also uses foreign currency operations as one of its types of monetary policy. The actions in the Federal Reserve take in the foreign currency market influence the value of the US dollar. If the Federal reserve wants to increase the value of the dollar, it will sell foreign currency to help bring up the value of the dollar and make foreign currency less expensive for Americans in foreign currency exchanges.
