The Federal Reserve System (or the Fed) is U.S. monetary authority responsible for monetary policy. In theory, it can control the fractional-banking money creation process and the money supply through open market operations (buying U.S. Treasury securities), a lower discount rate, and lower reserve requirements. In practice, the Fed primarily uses open market operations for this control.

An important side effect of expansionary monetary policy is control of interest rates. As the quantity of money increases, banks are willing to make loans at lower interest rates.

Open Market Operations

Expansionary monetary policy occurs when the Fed buys U.S. Treasury securities through open market operations. The Fed pays for these Treasury securities with bank reserves, which results in an increase in total amount of reserves held by the banking system. Banks are inclined to lend these extra reserves at lower interest rates, which increases checkable deposits and the money supply.

Discount Rate

Expansionary monetary policy occurs when the Fed lowers the discount rate. This makes it easier for commercial banks to borrow reserves from the Fed. As with open market operations, the additional bank reserves held by the banking system induces more loans at lower interest rates, which increases checkable deposits and the money supply.

However, because commercial banks do not undertake a great deal of reserve borrowing from the Fed, an increase in the discount rate alone is likely to have a limited impact on the money supply. For this reason, the discount rate is used primarily as a signal for other monetary actions, especially open market operations.

Reserve Requirements

Expansionary monetary policy occurs when the Fed lowers reserve requirements. This means banks have more reserves than needed to back up deposits. They can then use these extra reserves to make more loans at lower interest rates, which increases checkable deposits and the money supply.

Reserve requirements are an important part of the structure of the banking system. Banks commit to long-term, multi-year loans based on existing and expected reserve requirements. If the Fed changed reserve requirements frequently, then either the banking system will be unstable or banks will simply target the highest expected reserve requirements. For this reason, reserve requirements are seldom used as a monetary policy tool.

Stimulating The Economy

This is precisely the stimulation needed of the economy is in a business-cycle contraction or recession with high unemployment rates. It is also recommended if the economy appears to be headed toward a business-cycle downturn. In fact, because monetary policy does not affect the economy immediately, implementing expansionary monetary policy before the economy a contraction sets it is the preferred strategy. In this way the recession and higher unemployment are not just "fixed," but avoided completely.

Other Policy Options

• Expansionary Fiscal Policy: An alternative means of stimulating the economy is expansionary fiscal policy. This includes an increase in government spending and/or a decrease in taxes. Both actions increase aggregate expenditures, aggregate production, and employment. Expansionary fiscal policy can be used to complement expansionary monetary policy or as an alternative.


• Contractionary Monetary Policy: Monetary policy can also be used to address inflationary problems created by an overheated business-cycle expansion. Contractionary monetary policy is the opposite of expansionary monetary policy. It consists of selling U.S. Treasury securities through open market operations, raising the discount rate, and increasing reserve requirements. The resulting decrease in the money supply and increase in interest rates decreases aggregate expenditures, aggregate production, and thus reduces inflationary pressures.