The term “ monetary policy ” refers to what the Federal Reserve does to influence the amount of money and credit in the U.S. economy. Changes to the amount of money and credit affect interest rates (the cost of credit) and the performance of the U.S. economy. I n a simplified example, if you decrease the cost of credit, more people and firms will borrow money, which in turn will heat up the economy. T he Fed has 3 main tools at its disposal to influence monetary policy: open-market operations, setting the discount rate, and setting reserve requirements. T he Fed constantly buys and sells U.S. government securities in the financial markets, which in turn influences the level of reserves in the banking system. T hese decisions also affect the volume and the price of credit (interest rates). T he term “ open market ” means that the Fed does n’ t independently decide which securities dealers it will do business with on a particular day. R ather, the choice emerges from an open market where the various primary securities dealers compete. O pen market operations are the most frequently employed tool of monetary policy. T he discount rate is the interest rate that banks pay on short-term loans from a Federal Reserve Bank. T he discount rate is usually lower than the federal funds rate, though closely tied to it. I t is important because it is a visible announcement of change in the Fed ’ s monetary policy and gives the rest of the market insight into the Fed ’ s plans. T he reserve requirements is the amount of physical funds that depository institutions are required to hold in reserve against deposits in bank accounts. I t determines how much money banks can create through loans and investments. S et by the Board of Governors, the reserve requirement is usually around 10%. T his means that a bank might hold $10 billion in deposits for all of its customers, but does n’ t hold the physical money because they lend most of it out. T hese reserves are held either as vault cash or in accounts with the district Federal Reserve Bank. O f the three tools used to manipulate monetary policy, the use of open-market operations is the most important. T he Fed ’ s goal in trading the securities is to affect the federal funds rate —— the rate at which banks borrow reserves from each other. T he FOMC sets a target for this rate, but not the actual rate itself (because it is determined by the open-market). T his is what news reports are referring to when they talk about the Fed lowering or raising interest rates. All banks are subject to reserve requirements, but frequently fall below requirements in the carrying out of day-to-day business. T o meet requirements they have to borrow form each other ’ s reserves. T his creates a market in reserve funds, with banks borrowing and lending as needed at the federal funds rate. T herefore, the federal funds rate is important because by increasing or decreasing it, the Fed can impact (over time) practically every other interest rate charged by U.S. banks. Remember, the end goals of monetary policy are sustainable economic growth, full employment and stable prices. T hrough monetary policy, the Fed attempt s to tweak the economy to the right levels.