Monetary Policy
Monetary policy is one of the tools that the Government uses to influence the economy. Using its monetary authority to control the supply and availability of money, the government attempts to influence the overall level of economic activity in line with its political objectives such as low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by the Federal Reserve Bank in the United States. The Federal Reserve Banks’ policies influence the demand for or supply of reserves at banks transmitting the effects of monetary policy to the rest of the economy.

Monetary policy works through the market for reserves and involves the federal funds rate. A change in the reserves market will trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit in the economy, and levels of employment, output, and prices. For example, if the Federal Reserve reduces the supply of reserve money, the resulting increase in the federal funds rate tends to spread quickly to other short-term market interest rates, such as those on Treasury bills and commercial profit. Because interest rates paid on many deposits adjust only slowly, holding balances in money becomes less attractive. As the public pursues higher yields available in the market the money stock declines. Moreover, as bank reserves and deposits shrink, the amount of money available for lending may also decline. Higher costs of borrowing and possible restraints on credit supply will diminish growth of both bank credit and broaden credit measures.

The demand for reserves has two components, required reserves and excess reserves. All depository institutions must retain a percentage of certain types of deposits to be held as reserves. The reserve requirements are set by the Federal Reserve under the Depository Institutions Deregulation and Monetary Control Act of 1980. The total required reserves expand or contract with the level of transaction deposits and with the required reserve ratio set. However, the required reserve ratio is adjusted infrequently. Depository institutions hold required reserves in one of two forms: vault cash, cash on hand at the bank, or required reserve balances in accounts with the Reserve Bank for their Federal Reserve District. Depositories use their accounts at Federal Reserve Banks not only to satisfy their reserve requirements but also to clear many financial transactions.

Given the volume and unpredictability of transactions that clear through accounts every day, depositories maintain a cushion of funds to protect themselves against debits that could leave the accounts overdrawn at the end of the day and subject to a penalty. Depositories that find their required reserve balances insufficient provide such protection open supplemental accounts for required clearing balances. These additional balances earn interest in the form of credits that can be used to pay the cost of services, such as check-clearing and wire transfers of funds and securities, that the Federal Reserve provides. Some depository institutions choose to hold reserves even beyond those needed to meet their reserve. These additional balances, which provide extra protection against overdrafts and shortages in required reserves, are called excess reserves. They are the second component of the demand for reserves. In general,

depositories hold few excess reserves because these balances do not earn interest. Nonetheless, the demand for these reserves can fluctuate greatly over short periods, complicating the Federal Reserve’s task of executing monetary policy.