Question

 

Provide details about a central bank’s open market operations. Why are open market operations more advantageous than other tools of monetary policy?

Answer 1

Central Bank's Open market operations.

Open market oeprations are undertaken by the central bank of every country,incase of US,the Federal Reserve carries out these open market operations to implement the monetary policy.Now let us understand what exactly is the meaning of Open Market Operations.Open market operations refers to the buying and selling of the US treasury securities in the open market,in order to regulate money supply in the economy.There are three categories of Treasury securities,namely T- Bills which have the shortest range of maturity,T- Notes which have middle range maturity and T- Bonds which have the longest maturity period,they are also known as the "long bond".

The Federal Reserve puchases these Treasury Securities when it wants to increase the supply of money,and when it wants to decrease the money supply it sells these Treasury Securities.Manipulation of short term interest rate and supply of money in the economy is the main objective of Open Market Operations.Buying securities adds money to the economy,which reduces the interest rates and thus makes it easier to obtain loans.Selling securities removes money from the economy,which increases the interest rates and makes taking loans more expensive and difficult.

The Federal Open Market Committee(FOMC) undertakes Open Market Operations. FOMC sets target federal funds rate,which is the interest rate banks charge each other for overnight loans and then implements actions to meet the target.The federal funds rate influences various other rates like,home mortgage rate,credit card rate,savings deposit rate etc.

The Federal Funds Rate move only in two directions,up and down.which leads to expansionary or contractionary policy.If the Federal Reserve has a expansionary goal,it purchases the securities which pours cash into the banks.The banks are thus pressurized to give loans to the consumers,in this process the banks compete with each other to get more customers.This brings down the interest rate.This enables individuals as well as firms to borrow more.If the Federal Reserve has a contractionary goal,it sells securities,which pulls out money from the economy,leading to a increase in the interest rates.Consumers spend less,firms cut short their plans for growth and which in turn slows down the economy on the whole.

Open Market Operations are the most commonly used tool of the Federal Reserve when it wants to implement a certain monetary policy in the economy.The Federal Reserve has complete control over it and it is also very flexible and can be adjusted as and when required.The Federal Reserve has three basic tools to achieve its monetary policy objectives,which are bringing changes in terms and conditions for borrowing at the discount window,adjusting reserve requirement ratios and conducting open market operation.Among the three open market operations are the most important and flexible,and thus it is the most important.Open Market Operations play a very important role in managing the interest rates,maintaining the liquidity in the market as well as implementing the monetary policy.As the open market operations have a huge impact on the interest rate,which in turn effects the investment and employment.So overall Open Market Operations have effects on most important aspects of the economy and thus it is considered to be very important.