Question

Open market operations versus discount loans

Consider an expansionary open market operation. Suppose the Federal Reserve buys government securities from the nonbank public.

Suppose that the sellers of government securities deposit the checks drawn on the New York Fed into their bank account. Then, ceteris paribus, bank reserves  ? ,currency in circulation ?, and thus the monetary base will ?  

Suppose now that the Federal Reserve wants to increase the monetary base by increasing bank reserves only. Which of the following actions enables the Fed to achieve its goal?

1.Require commercial banks to repay discount loans

2. Lend to the non-banking public at the discount window

3.Lend to commercial banks at the discount window

4. Require the non-banking public to repay discount loans

By lending to commercial banks through the discount window, the Federal Reserve alters (currency in circulation, the discount rate, borrowed reserves, prices of government securities,or

nonborrowed reserves) and thus affects ( prices of government securities, banks’ willingness to borrow funds, the discount rate, the monetary base)

.

Answer 1

It has been provided that Federal Reserve buys the government securities from non-bank public.

The sellers of government securities deposit the checks drawn on New York fed into their bank account.

This action will increase the quantum of deposits with commercial banks and would also result in a corresponding increase in reserves held by banks.

So,

Bank reserves will increase.

Currency in circulation will remain unchanged.

Monetary base will increase.

If Fed wants to increase the monetary base by increasing bank reserves only then in such case it has to increase its lending to commercial bank at discount window as this will increase the bank reserves at banks.

Hence, the correct answer is the option (3) [Lend to commercial banks at the discount window].

Thus,

By lending to commercial banks through the discount window, the Federal reserve alters borrowed reserves and thus affects the monetary base.