Question

How does the Fed pursue its economic goals? How may the tools of monetary policy affect securities prices?

Answer 1

The US federal reserve or any other central bank mainly pursues its economic goals by the instruments of monetary policy. The FED has mainly three instruments of monetary control

1) Open market operations- these involves buying and selling securities by the Fed to and from the commercial banks of the country at a certain rate. These affects the cash flows of the private banks which affects the security prices due to the change in rate and amount of lending.

2) Reserve requirement- all the banks have to maintain certain reserves in the form of securities or cash to the Fed or within their vaults. Any change in reserve requirement may change the prices of securities as banks wont be able to grant credit to customers less than what it receives from the Fed or if the reserve requirement is too high, and bank is short of cash, it would further try to borrow money from other sources to meet fed requirement. So, it will affect the price of securities.

3) Discount rate- This is the third tool which the banks only use to borrow money from the Fed discount window when all others sources of borrowing funds fails. this is not a good sign for bank as many people may feel the bank is in some sort of financial trouble. This also in turn affect the securities prices as the banks in trouble wont be able to lend more money and also they will have to lend at a rate higher than the discount rate the bank has to pay to the Fed reserve.

So, in short all the instrument of monetary policy will affect the prices of securities directly or indirectly due to the change in liquidity or money supply in the market which happens when the central bank exercises its policies by altering rates.