Page 34 - Ultimate Guide to Currency Trading

the banks can lend out per dollar of deposit. Lending out more has the effect of increasing money
supply.

The Discount Rate

The second policy is the monitoring and setting of the discount rate. The discount rate is the overnight
interest rate that the Fed charges the retail banks to borrow short-term money. If the rate is low, or
goes lower, then retail banking institutions will borrow more from the Fed at a cheaper rate, and will
then be able to lend the money out at a cheaper rate. The increased lending also has the effect of
increasing money supply.

Open Market Operations

The third method of monitoring and controlling the money supply is through open market operations.
Open market operations involve the purchase and sale of T-bills, T-notes, and T-bonds on the open
market through a system of dealers, such as the nation's largest broker dealers and banks. It is often
considered the most effective and most mysterious tool at the Fed's disposal. Purchases and sales can
be done during different times, with or without notice to the public. The buying and selling of these
instruments is a function that goes on every day. The Fed takes a reading of the market by contacting
its sources: investment banks, brokerages, and other major players. It then enters into the process of
buying securities if there is not enough money in the system and selling securities if there is too much
money in the system. The whole process is usually done in secret, but lately there have been public
announcements of such activity.

Monetary Policy

In the United States, the Federal Reserve is the independent body that has the power to make and
enforce monetary policy. As with many other central banks, its main goal is to regulate the supply of
money and interest rates in such a way as to preserve price stability. The Fed does this through a
combination of controlling money supply, setting interest rates, and determining the amount of
available credit to banks.

This regulation of the economy through the methods of the Fed is referred to as monetary
policy. At the opposite end of the spectrum is fiscal policy. Fiscal policy refers to the efforts of
lawmakers to raise taxes and spend those funds in such a way as to spur growth of the economy.
There is some argument as to which method works best, but in the past decades, monetary policy has
been at the helm of the economic ship of most developed countries.