What role does the Federal Reserve play in the monetary and financial system, and what tactics does it use to influence monetary policy?

The Federal Reserve System essentially develops and carries out monetary policy by regulating the nation's money supply. The main tactic the Fed uses to accomplish this is raising and lowering interest rates, which also regulates the financial system because it has an effect on borrowing.

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The Federal Reserve System describes its roles in the following way:

  • Conduct the nation's monetary policy;
  • Provide and maintain an effective payments system; and
  • Supervise and regulate banking operations.

Two of these roles are directly referenced in this question. The main tactics the Fed uses to conduct the nation's monetary policy involve regulating banking operations.

The Fed can help determine how much money is in circulation by raising and lowering interest rates. These rates are known as "discount rates," and they do not refer directly to loans consumers receive from banks. Rather, the "discount rate" is the interest rate on loans that financial institutions themselves receive from the Fed.

If the Fed raises the discount rate, money literally becomes more expensive, and banks borrow and loan out less money. If they lower the discount rate, then banks can take out cheaper loans, and are therefore more likely to lower their own rates on loans to consumers. This puts more money in circulation.

The other main way that the Fed regulates monetary policy by regulating the banks is by raising and lowering reserve rates. The "reserve" is the amount of money financial institutions have to have in cash, and it is usually measured as a percentage of the money they have out in loans. If the reserve rate is higher, banks will have to reduce the loans they make, and this will reduce the money in circulation. Alternatively, they might borrow from the Fed or other banks, which is why the discount rate is so important.

Lower reserve rates (such as the current zero rate as of April 2020) will have the opposite effect: money in circulation will increase Of course, Congress and the President can influence the economy through legislation, but this is primarily fiscal policy, i.e., government spending. The Fed, which is theoretically independent of politics, manages monetary policy.

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