Question

I. What would happen to the nominal interest rate and quantity of money when the Fed decides to buy bonds through open market operations (OMO)?  Answer this using at least 100 words.

II. What if the Fed lowers the discount rate? What would happen to the nominal interest rate and quantity of money? Answer this using at least 100 words.

Answer 1

1. Open-market purchases lift bond prices, and lower bond prices on open-market sales. Thus, open market operations (OMOs) have a positive impact on bond prices. Interest rates have a negative impact on bond prices. As a result, open market purchases are reducing interest rates, and open market sales are increasing interest rates. OMOs are an instrument used by central banks in monetary policy implementation. OMOs include purchasing or selling shares, which are usually government bonds. Open market operations indirectly affect the cost of federal funds, which acts as a rate of interest on loans between banks. If the Fed purchases government securities from a bank, credit is transferred to the bank's assets. Even if it's not real cash, it's treated as such and has the same impact. It's equivalent to a direct deposit on your bank account that you may get from your employer. That provides more money for the bank to lend to customers.

2. The discount rate of the Federal Reserve is how much it pays its member banks to borrow from its discount window to retain the reserve it needs. Every night, the Federal Reserve requires them to have some cash on hand, known as the reserve requirement. Banks that borrowed so much that day need to borrow funds overnight to fulfill the criteria for the reserve. Typically, they borrow among themselves. The Fed has a back-up of the discount system in case they can't find the funds elsewhere.

Also if banks are not borrowing at the Fed discount window, they find all the other banks have also increased their lending rates. If it allows all interest rates to increase, the Fed increases the discount rate. That's considered a contractionary monetary policy and it's used by central banks to counter inflation. This reduces the supply of capital, slows loans and thus slows economic growth.

The opposite is called expansionary monetary policy, and it's being used by central banks to boost growth. It rising the discount rate, meaning that banks have to lower their interest rates to survive. It will increase the supply of capital, spur loans and improve economic growth.