One Federal Reserve rate decision can move bond prices, the dollar and stocks within minutes, and it can decide whether an issuer launches a stock offering that week.
Monetary policy is the management of the money supply and interest rates by the Federal Reserve (the Fed), the U.S. central bank. Fiscal policy is taxing and spending, decided by Congress and the President. The Treasury collects taxes and borrows, but it does not conduct monetary policy.
Expansionary policy raises aggregate demand (total spending) through lower rates, tax cuts or more spending. Contractionary policy cools demand to fight inflation through higher rates, tax increases or spending cuts.
Rate decisions reach the whole economy, so the vote is shared between the governors in Washington and the regional Reserve Bank presidents. The Federal Open Market Committee (FOMC), which directs open market operations, is the Fed's seven-member Board of Governors plus five Reserve Bank presidents, one always from New York.
Open market operations, the Fed's most used tool, are purchases and sales of U.S. government securities by the New York Fed's trading desk.
Common mistakes
- Wrong policy actor: Naming the Treasury or Congress as the source of open market operations. The FOMC directs them.
- Fed "sets" fed funds: The FOMC only targets a range. The discount rate is the rate the Fed sets, and any sound depository institution can borrow at it, not just member banks.
- Stale reserve ratio: An answer citing a 10% reserve requirement is outdated. The ratio is 0%.
Bottom line
- Monetary policy belongs to the Fed and its FOMC, while fiscal policy is taxing and spending by Congress and the President.
- When the Fed buys securities, reserves rise, the fed funds rate falls and bond prices rise, and selling does the reverse.
- Reserve requirement ratios have been 0% since March 26, 2020.
- The Fed sets the discount rate for sound depository institutions, while the prime rate, the broker call rate and Treasury yields are market rates.
Exam shortcut
Find the actor first. FOMC means monetary policy; Congress or the President means fiscal policy. For any Fed move, run one chain: the Fed buys, reserves go up, rates go down and bond prices go up. Selling reverses every step. Sort indicators by tense: a forecast is leading, "now" is coincident and confirmation is lagging. In offering questions, follow the money.
The full lesson (about 4,103 words, 27 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- A4
Browse all free SIE lessons or jump into free SIE practice questions.