Understanding Monetary Policy and Interest Rates

1.         Ask: What
are interest rates?  Elicit student
discussion to identify two ways to use the term interest rates.

The price paid (as a percentage) for the use of money…

a.         to savers for interest bearing bank
accounts.

b.         by borrowers for a loan or credit.

Explain that interest rates determine whether or how much
money people might borrow or whether or not they will save money to earn
interest.

Interest rates, like goods and services, are impacted by and
influence behavior according to the laws of supply and demand. 

Generally …

•   if Interest rates
for credit are high, people will demand (use) less credit.

•   if Interest rates
for credit are low, people will demand (use) more credit.

•   if interest rates
for savings are high, people will lend (save) more money.

•   if interest rates
for savings are low, people will lend (less) more money.

2.         Introduce
the basics of “monetary policy.”

Monetary policies are used by the Federal Reserve (central
bank) to control the supply of money, often targeting interest rates. Monetary
policy is to achieve goals of growth and stability of the economy.  These goals include stable prices, low unemployment
and growth of output. 

Monetary policy can be expansionary, leading to growth and
employment, or contractionary, a slowing of 3economic activity.  An expansionary policy increases the total
supply of money in the economy and a contractionary policy decreases the total
money supply.  Expansionary policy is
traditionally used to fight unemployment in a recession by lowering interest
rates.  Contractionary policy is used to
fight inflation. In contrast to monetary policy, fiscal policy (tax and spending
policies) can be sued to accomplish the same goals.

The Federal Reserve has three basic monetary “policy tools.”

•   Reserve Requirements.  Reserve requirements are the amount of funds
that a depository institution must hold in reserve against specified deposit
liabilities. Within limits specified by law, the Board of Governors has sole
authority over changes in reserve requirements. Depository institutions must
hold reserves in the form of vault cash or deposits with Federal Reserve Banks.

•   Discount Rate.  The discount rate is the interest rate
charged to commercial banks and other depository institutions on loans they
receive from their regional Federal Reserve Bank's lending facility--the
discount window.

•   Open Market Operations. Open market
operations--purchases and sales of U.S. Treasury and federal agency
securities--are the Federal Reserve's principal tool for implementing monetary
policy. The short-term objective for open market operations is specified by the
Federal Open Market Committee (FOMC). This objective can be a desired quantity
of reserves or a desired price (the federal funds rate). The federal funds rate
is the interest rate at which depository institutions lend balances at the
Federal Reserve to other depository institutions overnight.

Source: http://www.federalreserve.gov/monetarypolicy/default.htm

3.         Explain that
the primary tool of the Fed in recent times has been to target the federal
funds rate and to reach that target (interest rate) through open market
operations. 

•   The Federal
Reserve can sell securities to raise interest rates and slow the economy
(taking reserves out of the banking system). 
If banks have fewer reserves, interest rates increase and they can make
fewer loans.

•   The Federal
Reserve can buy securities to lower interest rates and stimulate the economy
(putting more reserves into the banking system).  If banks have more reserves, interest rates
decrease and they can make more loans

More Background
Information Online

FOMC: http://www.federalreserve.gov/monetarypolicy/fomc.htm

Open Market Operations: http://www.federalreserve.gov/monetarypolicy/openmarket.htm

Federal Funds Rate: http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm

For more classroom resources and teaching activities about the Federal
Reserve and monetary policy, go to: www.federalreserveedcustion.org.