The policy tools used by central banks, such as the Federal Reserve System, impact the quantity and rate of growth of legal reserves in the banking system and, in turn, the cost and availability of credit.

• The principal immediate target of Federal Reserve policy today is the federal funds interest rate, which, in turn, affects interest rates in both the money market and the capital market and, ultimately, the strength of the economy as a whole.



• The main policy tool used by the Federal Reserve to influence the cost and availability of credit is open market operations—the buying and selling of securities through the Trading Desk of the Federal Reserve Bank of New York. Open market sales tend to raise interest rates and restrict the supply of credit available, while open market purchases tend to lower interest rates and expand the supply of credit.



• The Fed, like many other central banks around the globe, has other policy tools at its disposal in the form of deposit reserve requirements and the discount (loan) rates of the individual Federal Reserve banks. An increase in reserve requirements or in the discount rate tends to tighten money and credit policy, slowing borrowing and spending, while a reduction in reserve requirements and discount rates tends to ease monetary policy, leading to an expansion of credit at lower cost.



• While open market operations, reserve requirements, and discount rates represent general credit controls, many central banks also have selective credit controls that impact specific groups or sectors of the financial system and the economy. The Federal Reserve’s selective controls include moral suasion (or psychological pressure applied by central bank officials) and margin requirements (which restrict purchases of selected securities on credit).



• As open market operations have become the central tool of many central banks around the globe, different varieties of this important central bank tool have been developed. Examples include straight or outright open market operations (where actual title to security ownership changes hands), repurchase agreements (where only temporary transfer of security ownership occurs), runoff transactions (where the central bank demands cash for maturing securities), and agency transactions (where the central bank acts to buy or sell securities on behalf of a central bank customer, such as a foreign government or foreign central bank).



• Besides central bank monetary policy, actions of the public (such as demanding additional supplies of currency and coin) and operations of the government’s treasury (such as collecting taxes) also impact interest rates and reserves in the financial system. The central bank must often act defensively to counteract these other sources of change in the financial marketplace, using its policy tools as a counterweight to the actions of the public and government.



• When the Federal Reserve decides to change the desired level of the federal funds interest rate, it uses open market operations to change the quantity of nonborrowed reserves held by depository institutions. Nonborrowed reserves plus borrowed reserves (loaned to depository institutions by the Federal Reserve banks) make up the supply of total reserves at the disposal of the banking system.



• The principal economic goals pursued by most central banks include the control of inflation, achieving maximum employment, and achieving sustainable economic growth. Unfortunately these policy goals may conflict, requiring the central bank to compromise, sometimes achieving only a portion of the goals it seeks.