Question

I have to create an essay on this topic. I have a few sources but am looking for someone else's logical explanation as well to help me understand. Please don't just copy paste a textbook page here. I have a textbook. Thanks! Q: Current Monetary policy Impact on Money Market Instruments

Answer 1

Ans.

"Monetary policy" refers to what the Federal Reserve, the nation's central bank, does to influence the amount of money and credit in the U.S. economy. What happens to money and credit affects interest rates (the cost of credit) and the performance of the U.S. economy.

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

Open market operations involve the buying and selling of government securities. The term “open market” means that the Fed doesn’t decide on its own which securities dealers it will do business with on a particular day. Rather, the choice emerges from an “open market” in which the various securities dealers that the Fed does business with – the primary dealers – compete on the basis of price. Open market operations are flexible, and thus, the most frequently used tool of monetary policy.

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

Open market operations involve the buying and selling of government securities. The term “open market” means that the Fed doesn’t decide on its own which securities dealers it will do business with on a particular day. Rather, the choice emerges from an “open market” in which the various securities dealers that the Fed does business with – the primary dealers – compete on the basis of price. Open market operations are flexible, and thus, the most frequently used tool of monetary policy.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.

In general, the functioning of the money market and its interaction with monetary policy receives little attention. The relationship between the policy rates determined by the Governing Council of the ECB and money market interest rates is typically close, stable and predictable. This is testimony to the design of the tools and procedures used to implement monetary policy decisions, and to the effectiveness of the liquidity policy conducted by the ECB and its communication.

However, while the stability of these relationships in normal times means that they are accorded little prominence in the analysis and discussion of monetary policy, the money market plays a unique role in signalling the stance of the monetary policy and in transmitting monetary policy decisions to financial markets more generally, to private spending and saving decisions, and ultimately to monetary dynamics and the determination of the price level. It is only when the normal, stable relationships in the money market break down – as was the case, at least temporarily, during the summer – that the centrality of their role becomes fully apparent.

The orderly functioning of the money market is of the utmost importance for the transmission of the key policy rates to the economy in general and the price level in particular. Market participants form expectations about the future path of the very short-term rates based on anticipated monetary policy decisions. These expectations are the basis for the determination of longer maturity interest rates and yields that are relevant for spending and saving decisions and which ultimately influence economic and monetary developments and the price level.

It is important to maintain a distinction between the determination of the monetary policy stance and its implementation through the conduct of liquidity policy. In normal times, ensuring that this distinction is maintained avoids that the intentions of monetary policy makers are confused by the (sometimes inevitable) noise that is introduced by liquidity policy decisions.

Maintaining this distinction may become even more important at times of stress, especially in the money market. Liquidity policy may need to be more active to contribute to the functioning of the money market, which exacerbates the scope for misunderstanding about monetary policy intentions.

the ECB response was governed by the likelihood that the turmoil in financial markets would have probably some implications for the outlook for price developments and thus for the course of a monetary policy resolutely focused on the maintenance of price stability. Consistent with its monetary policy strategy, the Governing Council conducted a comprehensive assessment of all factors that impinge upon the prospects for price stability and acted in a manner that best serves its primary objective. Since a major financial event such as the August money market turmoil has the potential to change the assessment of the prospects for price stability, monetary policy had to respond.

the monetary policy transmission to the overnight interest rate remains intact. There is also a clear pass-through from the interest rate on certificates of deposit to the slightly longer money market interest rates, which determine the exchange rate. This should be viewed in light of the banks’ wish to present a balance sheet to e.g. investors, authorities and credit rating agencies with as little risk as possible and as large a volume of liquid assets as possible. Consequently, they are unwilling to lend liquidity on an uncollateralised basis around the turn of the year, quarter and month. There are indications that this effect has become more important in recent years. The market participants mention that regulatory measures have contributed to this. Regulatory requirements apply not only at the time of calculation, but must be met on an ongoing basis

The bank rate is the minimum lending rate of the central bank at which it rediscounts first class bills of exchange and government securities held by the commercial banks. When the central bank finds that inflationary pressures have started emerging within the economy, it raises the bank rate. Borrowing from the central bank becomes costly and commercial banks borrow less from it.

LCR encourages banks to replace short-term funding, e.g. short-term uncollateralised money market loans, by longer-term loans. Liquidity regulation may also provide banks with an incentive to increase the LCR by borrowing from and placing funds at the central bank rather than via the market. This is not the purpose of the LCR. The aim is for banks to hold sufficient liquid assets and thus, in normal times, to manage their liquidity via the market rather than via National bank. There are no indications of banks using the monetary policy instruments to increase the LCR prior to its implementation.

The commercial banks, in turn, raise their lending rates to the business community and borrowers borrow less from the commercial banks. There is contraction of credit and prices are checked from rising further. On the contrary, when prices are depressed, the central bank lowers the bank rate.

It is cheap to borrow from the central bank on the part of commercial banks. The latter also lower their lending rates. Businessmen are encouraged to borrow more. Investment is encouraged. Output, employment, income and demand start rising and the downward movement of prices is checked.

Open market operations refer to sale and purchase of securities in the money market by the central bank. When prices are rising and there is need to control them, the central bank sells securities. The reserves of commercial banks are reduced and they are not in a position to lend more to the business community.

Selective credit controls are used to influence specific types of credit for particular purposes. They usually take the form of changing margin requirements to control speculative activities within the economy. When there is brisk speculative activity in the economy or in particular sectors in certain commodities and prices start rising, the central bank raises the margin requirement on them.

The recent The Forex markets are well-known for volatility, which is why it attracts such a large portion of global investment.Another important aspect of the forex market is the fact that it is largely focused on the short-term. This means when uncertainty is introduced, the result is mass-sell off, which then of course leads to a sharp decline in the price of the currency.

Complications with the negotiations, and the payment deals agreed to will play a major role in how investors react to the currency market. If the UK has to pay an exit bill, this large sum will affect confidence in the UK and affect the pound’s value poorly. If this is accompanied by a poor trade deal, and dim new trade prospects, the results could be disastrous. However, only time will tell.

Keep a close eye on Brexit negotiations, the Pound Sterling, as well as what the EU has to say. Fluctuations are to be expected anyway, let alone at such a turbulent time. However, developments in Brexit’s process, negative or positive, are sure to impact the currency markets greatly.

Federal Reserve is somehow responsible for all the economic ills that befall the country FED member banks borrow money overnight from each other. All other rates are set the same way that stock prices are: by auction, that is, the bid and ask for them, interest rates being inversely proportional to bond prices, so higher prices indicating more desirability causing lower interest rates. So, interest rates are low because people want to buy US debt. Period.