How the Federal Reserve Devises Monetary Policy

The Federal Reserve is responsible for creating the tools to influence the money supply and interest rates. These monetary policy tools facilitate its mandate of working toward maximum employment, price stability, and moderate long-term interest rates.

As of 2025, the Fed uses several tools it has created, such as open market operations, the discount window rate, interest on reserve balances, and overnight repurchase agreements to influence the economy.

Key Takeaways

• The Federal Reserve, the central bank in the United States, uses open market operations, discount rates, interest on reserve balances, and repurchase agreements to conduct its monetary policy.
• Open-market operations involve buying and selling government-issued securities.
• The discount rate is the primary interest rate that banks are charged to borrow from Federal Reserve Banks.

Devising Monetary Policy

The Federal Reserve is tasked with implementing monetary policy through actions that stimulate or constrain the economy. Since its creation in 1913, the Fed has created several tools while attempting to achieve its mandates. As of 2025, the tools it created and uses to implement monetary policy are primarily:

• The Discount Window
• Interest on Reserve Balances
• Open Market Operations
• Repurchase Agreements

The Discount Window

The discount window is where banks can borrow from Federal Reserve Banks. The discount rate is the primary interest rate that banks are charged at the discount window. Under this program, qualified depository institutions can receive three different rates:

• The primary rate is used for short-term loans, which are extended overnight to banking and depository facilities with a solid financial reputation. This rate is usually set above the short-term market rate levels.
• The secondary credit rate is slightly higher than the primary rate and is extended to facilities that have liquidity problems or severe financial crises.
• Finally, seasonal credit is for institutions that need extra support on a seasonal basis, such as a farmer’s bank. Seasonal credit rates are established from an average of chosen market rates.

To use the discount window, banks must provide collateral for the loans they are taking, which is another way the Fed encourages lending between banks, along with setting the discount rate higher than IORB or repurchase rates.

Interest on Reserve Balances

The Federal Reserve used to require that banks keep a certain percentage of their deposits in reserve with the Fed, but this requirement was dropped to zero in 2020. The Fed still provides reserve accounts for banks to use, but it now pays them interest on the funds they keep there, and it calls this Interest on Reserve Balances (IORB).

However, the Fed sets the interest rate on IORB at a level that makes banks decide whether lending to other banks is more profitable or keeping money in their reserve account. This is the Fed’s primary method of maintaining a federal funds rate within the range it sets.

Open Market Operations

Open market operations are essentially the buying and selling of government-issued securities (such as U.S. Treasury bills, or T-bills) by the Federal Reserve. The short-term purpose of these operations is to increase or decrease the supply of money, which assists the bank in maintaining the effective federal funds rate within its target rate range.

Repurchase Agreements

Repurchase agreements work in two ways: First, the Fed can purchase securities from banks and agree to sell them back for more, earning the banks interest. Second, the Fed can sell securities to banks and repurchase them for less, providing an earning opportunity for the banks as well (this is a reverse repurchase).

These rates are set lower than the other rates used, with the overnight reverse repurchase rate set just above the floor of the target rate range.

Note

The discount and overnight reverse repurchase rates help the Fed set the target rate range.

What Is Monetary Policy In Simple Terms?

Monetary policy is how a central bank controls and manages interest rates and the money supply to influence economic expansion and contraction.

How Can Monetary Policy Reduce Inflation?

Monetary policy doesn’t act to reduce inflation, but it acts to control the inflation rate. By using interest rates to influence banks to lend more or less and manipulating the money supply, the central bank can increase or decrease the inflation rate.

What Is an Example of Monetary Policy?

If a central bank buys or sells securities from commercial banks, it is using one of its monetary policy tools to increase or decrease the money supply in the bank’s reserve account. These actions assist it in its efforts to influence the economy.

The Bottom Line

A central bank’s monetary policy affects the state of a country’s economic affairs by influencing the money supply and interest rates. Thus, the Federal Reserve becomes indirectly influential on the prevailing interest rates that affect almost every financial aspect of our daily lives.