Question

GENERAL BUSINESS COURSE QUESTION:

Joe and Jill were talking about the role played by the Federal Reserve System in the United States. Joe seemed to be quite well informed about the functions and activities of our central bank. "You see, Jill, the Fed is the main guardian of our nation's economic stability," Joe declared. "In America, we don't want inflation and we don't want recession. To stretch the situation just a bit, we are frightened, absolutely terrified, by thoughts of hyperinflation and depression. So, the Fed maintains the right to alter the situation and protect us from these two monsters. And you ask, how they do that? The answer is the discount rate. That is the device that the Federal Reserve System uses to keep us safe."

Jill was enjoying listening to her friend explain it all. Joe continued, "Now the discount rate is the interest rate that the twelve Federal Reserve Banks around the country charge their member banks on a loan. So, when the discount rate goes up, all interest rates tend to go up. And, happy to say, when interest rates go up all over America, this tends to slow down any inflationary tendencies." Jill asked, "Does the Fed have other tools for stopping inflation?" "No," said Joe.

2) Joe probably can't answer this question, but you can. What happens in the Fed's open market operations?

Answer 1

Apart from discount rate Fed can use other tools also to control or expand money supply in the market.

The Federal Reserve’s three instruments of monetary policy are open market operations, the discount rate and reserve requirements

The discount rate is the interest rate charged by Federal Reserve Banks to depository institutions on short-term loans.

Reserve requirements are the portions of deposits that banks must maintain either in their vaults or on deposit at a Federal Reserve Bank.

An open market operation is an activity by a central bank to give or take liquidity in its currency to or from a bank or a group of banks.Open market operations consists of the buying or selling of government securities.

Expansionary Monetary Policy

Expansionary monetary policy is used when economy is sluggish .The basic purpose of this monetary policy is to increase money supply and increase aggregate demand by lowering the interest rates.

Following are steps taken by Fed related to open market operations in case of Expansionary Monetary Policy:

• When the Fed buys government securities through securities dealers in the bond market, it deposits the payment into the bank accounts of the banks, businesses, and individuals who sold the securities.
• Those deposits become part of the funds commercial banks hold at the Federal Reserve and thus part of the funds commercial banks have available to lend.
• Because banks want to lend money, to attract borrowers they decrease interest rates, including the rate banks charge each other for overnight loans (the federal funds rate).

Contractionary Monetary Policy

Contractionary monetary policy is used to control inflation. This is done by increasing the interest rates, reducing the aggregate demand and money supply in the economy.

Following are the steps taken by Fed related to open market operations in case of Contractionary monetary policy.

• When the Fed sells government securities, buyers pay from their bank accounts, which decreases the amount of funds held in their bank accounts.
• Banks then have less money available to lend.
• When banks have less money to lend, the price of lending that money, the interest rate goes up and that includes the federal funds