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Montary policy's tools for benchmark interest rates

What is the role of the Federal Reserve System and what are the key instruments of monetary policy it uses? Describe briefly how each of them works.

Discuss the key factors that the Fed must take into account when deciding whether or not to change the benchmark interest rates. In the current policy discussions on monetary policy, what do economists mean by the risk of the Fed overshooting?

Solution Preview

The Federal Reserve, as the central bank of the United States, enacts monetary policy. Monetary policy can be used to control inflation or improve the economy. Open market operations are the primary tool of the Federal Reserve, and are quite powerful. This is what the Federal Reserve actually does when it announces a new target for its federal funds rate. The federal funds rate is the interest rate banks charge one another in return for a loan of reserves. If the supply of reserves is reduced because the Federal Reserve has sold bonds (contractionary policy), that interest rate is likely to increase. If the supply of reserves is increased because the Federal Reserve has purchased bonds (expansionary policy), that interest rate is likely to decrease.

Other tools are:
Discount window lending: Banks borrow directly from their Federal Reserve Bank's lending facility (the discount window), at rates set by the Reserve Banks and approved by the Board of Governors. Changing these rates influences how much money banks have to lend. When there is ...

Solution Summary

Monetary policy tools and decision process when interest rate targets are changed. Currenty policy discussions of monetary policy and risk of overshooting.

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