Controlling the Money Supply and Monetary Policy

The most important of the Fed’s responsibilities is putting together and carrying out monetary policy. The function of establishing and managing monetary policy is the Feds highest profile task. Acting as monetary manager, the Fed must balance the volume of money and credit, interest rates and the demands of the economy. The object of monetary policy is to influence the performance of the economy as reflected in such factors as inflation, economic output, and employment.

Changes in monetary policy are gradual processes that are put in place to influence how much money and credit will be available to the economy. This influence will place pressure on the supply of credit mainly by raising and lowering short-term interest rates. Hence, changes in monetary policy will lead to changes in rates paid on short-term interest bearing assets such as, bank checking accounts, money market deposit accounts, certificates of deposits and money market mutual funds. As a rule, the changes in short-term rates lead to changes in long-term rates as well.

The creation of new money in the U.S. economy is primarily handled at retail banks and credit unions. They are the central channels used by the Federal Reserve to control the money supply. By controlling reserves and influencing interest rates on the money it lends and borrows from the retail banks, the Federal Reserve is able to regulate the supply of money to individuals and companies.

Federal Reserve actions directly affects only one side of the supply and demand relationship, it cannot totally control interest rates. Nevertheless, monetary policy clearly does affect the general level of interest rates. The Fed acts to influence the availability of money and credit by adjusting, one way or another, the level or rate paid on bank reserves.

There are three main tool of monetary policy that the Federal Reserve uses to influence supply of money: by setting reserve requirements that banks must hold, by buying and selling government securities in open market operations and by adjusting the discount rate, which affects the price of reserves banks borrow from the Fed through the discount window. These instruments of monetary policy will influence the supply of credit, but do not directly impact the demand for credit.

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