Question

What are the major differences between a discount loan and an open market purchase with respect to their respective effects on monetary base? Explain using an example and showing the relevant changes in the balance sheets of the Fed and the Banking System. Between these two actions, is one preferred to the other by the Fed? Why or why not?

Answer 1

In case if a discount loan the Fed calculates the interest and other related charges and discounts them from the face amount before lending to the public. However, the borrower has to pay back the whole amount – the principal, the related charges and the interest. This thus benefits the public at the time of purchase. This will go in as an asset in the Feds balance sheet and will increase money supply in the economy, but can be a nonperforming asset in the future. An open market purchase on the other hand will mean that bonds are purchased and money sypply increased by the Fed. This will increase the assets side of the balance sheet as the money supply rises and bonds are purchased. The Fed will always prefer an open market purchase of bonds as it eliminates the chance of defaults which are there in case of discount loans. The Fed also has the flexibility to buy and sell bonds at its convenience through open market operations but bonds pose a liability risk and can become non performing assets if they are not repaid.Thus the Fed will always prefer open market operations.