The Federal Reserve Bank has been mandated by the Congress to execute monetary policies on behalf of the government in a meticulous manner such that the system remains liquid at all times. The FEDS has two specific mandates assigned by the Congress; one, to ensure that there is the sustainability of employment opportunities and output and two, to stabilize prices of commodities (or stabilize the rate of inflation), (Engen, Laubach and Reifschneider 2-3). To ensure that these mandates are met, the FEDS sets achievable and sustainable targets for the interest charged on loans as well as the Federal Reserve funds, which are overnight credit facilities ...view middle of the document...
When more money has been created through the sale of these securities, the Federal Funds Rate is deflated making more money available for circulation in the system. Reduction in the federal funds rate leads to the decrease in the short-term interest rates, which promotes consumer spending, as consumers tend to have more disposable income. The increased consumer spending stimulates economic growth as the volume of traded commodities increase in the public market. When the target for the reserve funds is reduced, fewer securities will be sold in the open market leading to lesser funds in the reserve fund, (Labonte 10). This pushes up the reserve funds rate, making market interest rates to increases. As a result, the consumers will have lesser disposable income, the volumes of trade will reduce, and the inflationary pressure will be reduced as well.
The next common tool used by the FEDS to execute its monetary policy is the discount rate, which is the interest it charges to financial institutions that borrow short-term funds, (Labonte 4). This tool is motivated by the powers of demand and supply in the banking sector, in which banks may be hit with a liquidity crisis and may need quick cash to maintain their operations, (Labonte 11). The discount rate is usually determined by the board of directors of the FEDS and approved by the board of governors, (Engen, Laubach and Reifschneider 17). These rates are usually set above the Federal Reserve funds rates to serve as a secondary source of funds for the depositors.
The other tool is the interest on reserves. The Federal Reserve Bank pays interest on reserve held on behalf of the depositors, and the interest rates are significantly higher than what the banks would earn if they lent the money to fellow banks or to the public, (Labonte 6). Given that no bank would be willing to put their money where they would earn less than what they get if they leave their money with the FEDS, they choose to leave...