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The federal bank controls the economy by regulating country’s interest rates, aggregate demand, and money supply
The three functions of money are acting as store of value to transfer purchasing power from present to future, medium of exchange between buyers and sellers and a unit of account.
Money supply can be categorized into three groups or classes: The M1 consists of traveler’s checks and currency owned by individuals and businesses, M2 includes M1 and savings, time, and other types of deposits. M3 includes M1 and large scale, term and time deposits.
The three monetary policy tools
- Reserve requirements
- Federal funds rate
- Open market operations
- When the fed wants to lower the money supply in the economy, it raises the reserve requirements.
- Reserves are the amount of money that each commercial bank holds in their vault
- When reserve requirements increase, the commercial banks are supposed to hold more money which reduces the amount available to lend to borrowers.
- Fewer loans mean there will be a shortage of loans, and commercial banks are forced to raise interest rates, this decreases loans and eventually decreases the money supply. Less money means the prices of goods and services will go down as well.
- On the other hand, if the fed wants to raise money supply in the economy, it will do the opposite by decreasing reserve requirements allowing the commercial banks to lend more money.
Federal funds rate
- Fed funds rate is the interest rates the commercial banks pay for overnight borrowing.
- When the federal funds rate decreases, commercial banks also charge lower interest rates and more loans are made accessible to the borrowers
- If the government wants to increase the money supply in the economy, it will raise the federal funds rate so that the commercial banks can charge borrowers more interest rates, decreasing demand for loans.
- This will eventually lower the aggregate demand while stabilizing the economy.
Open market operations
- Open market operations refer to the sale and purchase of government securities and bonds to the commercial banks
- If the government wants to decrease the money supply to avoid inflation, it will decrease reserves in commercial banks by selling securities.
- The commercial banks will then charge high-interest rates due to a shortage and less money will be available in the vault to lend out to borrowers
- If the fed wants to stimulate the economy by raising money supply and aggregate demand, it will do so by purchasing securities from the commercial banks.
- This will increase money in the banks’ vaults, hence lowering interest rates, Borrowers will be able and willing to borrow more and hence an increased investment and aggregate demand.
- The three tools are used by the fed to control the economy and avoid fluctuations between deflation and inflation
|Federal funds rate||The interest rate on overnight loans of reserves from one bank to another|
|Demand curve for reserves||Consists of required reserves (based on required reserve ratio and deposits) and excess reserves|
|Supply Curve||Consists of nonborrowed reserves (from Fed’s open market operations) and borrowed reserves|
|Open Market Operations||Purchase increases federal funds rate, sale decreases federal funds rate|
|Discount lending||Changes in discount rate have little effect on federal funds rate|
|Reserve requirements||Increasing requirements raises federal funds rate, decreasing requirements lowers federal funds rate|
|Conventional monetary policy tools||Open market operations, discount lending, reserve requirements|
|Open market operations – Dynamic||Intended to change the level of reserves and the monetary base|
|Open market operations – Defensive||Intended to offset movements in factors affecting reserves and the monetary base|
|Repurchase agreement||Fed purchases securities with agreement for seller to repurchase within a short period|
|Matched sale-purchase transaction||Fed sells securities with agreement for buyer to sell them back in the near future|
|Discount window||Facility for banks to borrow reserves from the Federal Reserve|
|Standing lending facility||Primary credit facility allowing healthy banks to borrow short maturities|
|Lender of last resort||Role of the Fed to provide reserves to banks when no one else would, preventing bank and financial panics|
|Advantages of Open market operations||Initiative of the Fed, flexibility, reversibility, quick implementation|
|Zero-lower bound problem||Inability of central bank to further lower short-term interest rates due to reaching zero|
|Nonconventional monetary policy tools||Liquidity provision, asset purchases, commitment to future monetary policy actions|
|Liquidity provision components||Discount Window Expansion, Term Auction Facility, New Lending Programs|
|Quantitative easing||Expansion of balance sheet leading to increased monetary base|
|Credit easing||Altering Fed’s balance sheet to improve functioning of specific credit markets|
|Forward guidance||Committing to keeping federal funds rate at zero to lower long-term interest rates|
|Target Financing Rate||Sets target for the overnight cash rate|
|Overnight cash rate||Interest rate for very short-term inter-bank loans|
|Main refinancing operations||Predominant form of open market operations, similar to repo transactions|
|Reverse transactions||Credit operations against eligible assets, reversed within two weeks|
|Longer-time refinancing operations||Monthly operations involving purchases/sales of securities with three-month maturity|
|Marginal lending facility||Banks can borrow overnight loans from national central banks at marginal lending rate|
|Deposit facility||Facility where banks are paid a fixed interest rate below the target financing rate|
|Functions of money||Store of value, medium of exchange, unit of account|
|Money supply classifications||M1 (currency, traveler’s checks), M2 (M1 + savings, time deposits), M3 (M1 + large-scale deposits)|
|The three monetary policy tools||Reserve requirements, federal funds rate, open market operations|
|Reserve requirements||Increasing requirements reduces money supply, decreasing requirements increases money supply|
|Federal funds rate||Decreasing rate increases money supply, increasing rate decreases money supply|
|Open market operations||Selling securities decreases money supply, purchasing securities increases money supply|
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Editorial Team. (2023, May 24). Monetary policy tools: Reserve requirements, federal funds rate, and open market operations. Help Write An Essay. Retrieved from https://www.helpwriteanessay.com/blog/monetary-policy-tools-reserve-requirements-federal-funds-rate-and-open-market-operations/