Question

-Explain how the central bank conduct monetary policy by targeting the federal fund rate, and through open market operation.

Answer 1

Targeting federal funds rate:

This is the rate at which banks park excess funds with other banks from their reserves. This is to maintain certain reserve requirements. For example. if at end of the day, a bank needs more reserves to maintain its reserve requirement, it can borrow from other banks at this rate. If federal funds rate increase, then it is costly for banks to borrow from others. So, in order to maintain balance, banks make less loans, so market interest rate increase. On the other hand, if federal funds rate is lowered, banks make more loans and interest rate falls. So, Central bank maintains interest rates by controlling federal funds rate.

Open market Operations:

This refers to selling and buying government securities in the market. Through open market operations, a Central bank can control money stock in the economy. If central banks sells G-secs, then people will exchange them from cash. Hence, the stock of money falls in the economy. This is called contractionary monetray policy. Whereas, to increase the money stock, it buys G-secs, for which it pays through cash. This is called expansionary policy.