Question

What are the three instruments of monetary control? Explain. Why does the Federal Reserve prefer to use open market operations? Explain. How can the Federal Reserve use its open market operations to expand or contract the nation’s money and credit supply? Explain in some detail. Describe the workings of the Federal Open market Committee which controls monetary policy. Give a detailed account of how monetary policy works to change interest rates, aggregate demand, and the macroeconomy.

Answer 1

Introduction

The Federal Reserve of the United States was established in the year 1913, with a view that it would help in correcting bank runs which were times in which the depositors would rush to banks to withdraw all of their money at once. Over the years, the bank has become the primary tool for managing the economy and making sure that commercial banks adhere to strict norms so that public money is not mishandled by them. It is widely said to be the bankers bank.

The following are three policy instruments, the role of the Federal Open Market Committee and the detailed manner in which the organization regulates interest rates, demand and the overall macro economy.

Case Specifics: -

1) Cash Reserve Ratio: -

The first and foremost tool used by the Federal Reserve to correct the economy is Cash Reserve Ratio. The Cash Reserve Ratio is the minimum amount of money, which the commercial banks must hold with the Federal Reserve at any given point of time. The remaining deposits can be used by the bank to give away as loans to the general public and to companies it chooses to.

Whenever the economy demands, and is in recession or in inflation, the Cash Reserve Ratio is altered which directly impacts demand, interest rates and other similar variables.

Consider an environment of low growth wherein the total demand in the country is low. The cash reserve ratio requirements then are limited by the Federal Reserve. This lowering of the Cash Reserve Ratio gives commercial banks access to more money in circulation and they increase their lending and lower interest rates. When interest rates are lowered and the availability of credit is more, the economy comes back into shape as the total demand increases and all other variables such as employment availability and producers’ gains are realized. The increased demand is an added incentive for producers to produce more and gain more. The exact opposite happens whenever there is inflation in the economy.

These two tactics are known as contraction or expansion of the monetary policy.

2) Discount Rate: -

The second is discount rate. This is the rate at which the commercial banks are granted loans by the Federal Reserve for their operations. When the Federal Reserve chooses to reduce or increase the same, it has a direct impact on the interest rates which are charge by the banks. As a result, the economy displays contraction or expansion which is described in the first section.

During an inflation, the discount rate is hiked. This means that it now expensive for commercial banks to take a loan from the Federal Reserve. As a result, this is passed on to the consumers and loans become expensive for them. The aggregate demand which is causing inflation reduces, and the economy returns back to normal. The exact opposite takes place when there is deflation in the economy.

3) Open Market Operations and Committee: -

The core aim of the Open Market Committee is to maintain the Gross Domestic Product and keep inflation or deflation in check. It does so by directly participating in open market operations which are described as follows: -

Open Market Operations are an exercise through which the Federal Reserve of the country purchases or sells bonds in the market to directly influence the supply of money in the economy. This is the most used tool and is favoured by the Federal Reserve as the impact from the same is instant in nature. The real time change is not observed if the Federal Reserve uses the above 2 mentioned options and it takes some considerable time before which the effects of the above 2 options can be observed in the economy.

Open market operations on the other hand happen instantly and its effects also happen at the same time. For example, during a deflation, the open market committee decides on the quantity of bonds to be bought in the market. With this purchase, the banks that participate in the same have higher availability of capital and can then use to lend in their markets and instantly the flow of money in the economy is increased. The exact opposite happens during inflation when the Open Market Committee decides to sell bonds and collect money to reduce the supply of money in the economy respectively.

Please feel free to ask your doubts in the comments section.