Question

1- how is federal reserve monetary policy linked to the degree of interest rate uncertainty faced by financial institutions?

Answer 1

Federal reserve act as regulator of monetary policies hence, federal reserve has ability to influence the financial institution’s profitability by way of bringing the regulations, increasing the supply of the money or restricting the supply of the money in the money market.

·      Federal reserve banks can increase its lending rate and that will increase the interest cost and it will finally affect the demand of money in the market.

·      Federal Reserve Bank (Fed) can reduce the interest rates at which financial institutions borrow from the Fed. How this will impact? As interest rates are reduced the banks or financial institutions will be able to borrow at lower cost from Fed. Suppose, $ 1 Billion was earlier borrowed at 1% p.a which was equivalent to $ 10 million interest cost after reduction in interest rate same $ 1 Billion can be borrowed at 0.75% p.a hence, the cost of borrowing will become $ 7.5 million. Now, banks can go ahead and lend at lower cost to their clients. As client or borrower can borrow at lower cost they can spend more money at lesser cost. The flow of money will increase purchasing power of individuals. Purchasing power will chase the limited supply of goods and prices of goods would rise hence, inflation number will also rise

·      Federal reserve bank tightens the reserve requirements of the bank. Reserve requirements are Minimum Cash Reserve Ratios, ratio of mandatory holding of treasury bonds or government Securities by financial institutions and banks and that can bring down the loanable amount of the banks to corporation and retail investors which will fundamentally impact the supply of money.

·      Federal Reserve Bank can relax the reserve requirements. This can indirectly improve the supply of money. The tight reserve requirements hold / contain the money supply in the market. The banks or financial institutions cannot lend these monies to their corporate or retail borrowers as reserve ratios are regulatory requirement. As fed relaxes the financial institutions from restrictive reserve ratios then the natural supply of money will increase. The supply of more money improves the purchasing power of individuals hence the inflation numbers goes up.

·      Federal reserves bank can issue new bonds to suck the liquidity in the market. Government bodies paying good rates pulls the money from depositor to government institutions which results in less inflow for banks and institution which finally brings institutions in low profit zones.

·      Federal Reserve Bank can go ahead and create the new currencies either electronically or by printing new currencies. New supply of money can be flown by purchase or buy back of existing government and treasury securities. This activity is broadly classified as quantitative easing. This method directly or indirectly increases the supply of currency in the market and helps improving the purchasing power of the individuals and ultimately results in inflation.

Federal reserve can regulate monetary policies and accordingly increase or decrease the supply of money in tune to targeted inflation.