One of the Federal Reserve’s main jobs is to monitor and stimulate the economy of the US, to do so, the fed is using many tools, and these tools are forming the monetary policy, here are some of these tools.
1. Required reserve ratio:
This is the amount of deposit that banks has to keep with the fed. The fed is changing this amount corresponding the economy state. The fed is rarely changing this amount since it usually results in high cost incurred by the banks. Decreasing this amount would result into increasing the amount of money available for the banks to lend, which could stimulate the markets. On the other hand, a higher reserves required by the fed, would end to less money in the banking system to lend, which would cool down the economy.
2. Fed fund rate (Interest rate):
This is the rate that a bank charge another bank when lending money overnight to meet reserve requirements. Banks has to fulfill the required reserve by the fed by the end of each day, those banks who faces a deficit, would go and borrow from another bank, this loan is called the fed fund, and the rate at which this loan is offered is called the fed fund rate. The banks has the right to set the rate they like when borrowing from each other, while Federal open market committee will set a target for the fund rate, and control this target through open market operations, which include buying or selling government securities (injecting or taking money from banking system) to reach the desired rate.
3. The Repo rate:
This is the rate by which the federal reserve lend short term loan to commercial banks. In case of a shortage of cash, banks and financial institutions sells government securities to the federal reserve for cash, with a commitment to repurchase these securities with a slightly higher price. This is one of the methods that the fed is controlling money supply in the economy. When decreasing the repo rate, that will urge the banks to sell the government securities to the fed and having cash, which will increase the money supply in the system. The opposite will happen when increasing the repo rate.
4. Discount rate:
This is the rate by which banks borrow money from the fed to meet the required reserve. This rate is usually higher than the fed fund rate - the target rate set by the FOMC-. The discount rate push the borrowers to borrow from banks rather borrowing from the fed, as banks gives the funds with less cost. Furthermore, it pushes the lenders to set the lending rate below the discount rate to attract borrowers. The discount rate is used by the federal reserve to control the fed fund rate.