Understanding monetary policy is such a very important issue that it makes financial sense to know it and how it affects the national and worldwide financial condition.
In the US, the Federal Reserve is mandated to set the monetary policy, which regulates money and credit. Whatever happens to the nation’s money and credit influences inflation, interest rates, unemployment and the total economic health and performance. To achieve these goals, Federal Reserve focuses on its three instruments of monetary policy: open market operations, discount rate, and reserve requirement.
It is the work of the Federal Open Market Committee to decide on the operations of open market. The Committee involves the Federal Reserve in buying and selling securities like bills, treasury bonds and notes. When the Federal Reserve buys these securities, the payments are deposited to the securities dealer or with a bank. The bank can loan out the money to stimulate the economy and boost interest rates. When the Federal Reserve sells the securities, value is deducted from the account of the purchasing bank. This reduces money supply to slow down the economy and increase interest rates.
The Federal Reserve charges the discount rate to other financial institutions in relation to short term loans. When the discount rate is low, the banks will more likely resort to borrowing. This will increase the supply of money and would stimulate growth. On the contrary, when the discount rate is high, the economy tends to slow down.
In reserve requirements, banks receive instruction from the Federal Reserve on what portion of the deposits are forwarded to the Federal Reserve Bank and what portion is kept in their vaults. When reserve requirement is high, banks lend less and cost of credit increases while low requirement has the opposite effect.