Monetary Policy

• Author: Edward Hsieh
• Pages: 515-517

Page 515

The central agency that conducts monetary policy in the United States is the Federal Reserve System (the Fed). It was founded by the U.S. Congress in 1913 under the Federal Reserve Act. The Fed is a highly independent agency that is insulated from day-to-day political pressures, accountable only to Congress. It is a federal system, consisting of a board of governors, twelve regional Federal Reserve Banks (FRBs) and their twenty-five branches, the Federal Open Market Committee (FOMC), the Federal Advisory Council and other advisory and working committees, and 2,900 member banks, mostly national banks. By law, all federally chartered banks, that is, national banks, are automatic members of the system. State-chartered banks may elect to become members.

The seven-member board of governors, headquartered in Washington, D.C., is the core agency of the Fed, overseeing the entire operation of U.S. monetary policy. The FRBs are the operating arms of the system and are located in twelve major cities, one in each of the twelve Federal Reserve Districts around the nation. The twelve-member FOMC is the most important policy-making entity of the system. The voting members of the committee are the seven members of the board, the president of the FRB of New York, and four of the other eleven FRB presidents, each serving one year on a rotating basis. The other seven nonvoting FRB presidents still attend the meetings and participate fully in policy deliberations.

MONETARY POLICY AND THE ECONOMY

Being one of the most influential government policies, monetary policy aims at affecting the economy through the Fed's management of money and interest rates. The narrowest definition of money is M1, which includes currency, checking account deposits, and traveler's checks. Time deposits, savings deposits, money market deposits, and other financial assets can be added to M1 to define other monetary measures, such as M2 and M3. Interest rates are simply the costs of borrowing. The Fed conducts monetary policy through bank reserves, which are the portion of the deposits that banks and other depository institutions are required to hold either as vault cash or as deposits with their home FRBs. Excess reserves are the reserves in excess of the amount required. These additional funds can be transacted in the reserves market (the federal funds market) to allow overnight borrowing between depository institutions to meet short-term needs in reserves. The rate at which such private borrowings are charged is the federal funds rate.

Monetary policy is closely linked with the reserves market. With its policy tools, the Fed can control the reserves available in the market, affect the federal funds rate, and subsequently trigger a chain of reactions that influence other short-term interest rates, foreign-exchange rates, long-term interest rates, and the amount of money and credit in the economy. These changes will then bring about adjustments in consumption, affect saving and...