The Federal Reserve which is commonly referred to as FED is the central authority to the US money and banking system. It utilizes the monetary policies at its disposal with the aim of ensuring that prices, foreign exchange rates as well as long term interest rates remain stable. Stability in these three areas is beneficial in as far as investment is concerned and they trigger economic growth. (McConnell and Brue, 2004).
Other objectives of FED include ensuring that the inflation rate is kept relatively low and the employment levels boosted. The monetary policies adopted include the open market operations, manipulating of the reserve requirement and discount rates. The open market operations refer to the buying of US treasury as well as the federal agency securities with the aim of influencing the money supply and demand. OMO is the most applied tool due to its flexibility in influencing money demand.
Fed also ensures that the financial sector remains stable while protecting the interests of the customers due to the realization of the importance of money supply in the economy. (www.federalreserve.gov).
One challenge that faces FED as it tries to ensure economic growth through the various monetary policies is the fact that realizing one aim results to another problem or rather poses a different challenge. Selling government securities with the aim of increasing the money supply in an economy may trigger increased inflation by some margin. Increasing the employment levels also triggers inflation which Fed tries to counter in the first place. To ensure that the impact of such inflation is contained, it is imperative that Fed sets its target appropriately so that a compromise is attained. Attaining one objective at the expense of the other should be well addressed.
Timing issues which emanates from the fact that there is a time lag between when Fed realizes or rather recognizes a problem and decides to react by selecting an appropriate monetary policy and when the effect of the implemented policy is felt. To ensure increased efficiency in the monetary policies, Fed must adopt effective tools or strategies of gathering information to ensure that immediate responses are made as demanded by the economy. (McEachern, 2005).
Fed structure is quite complex thus making the implementation of its policies difficult and cumbersome. This also contributes to the delayed implementation of monetary policies which has a negative effect in as far as attaining the core objectives is concerned. The board of governors of Fed are also too powerful and can be manipulated easily especially by the political leaders who have some vested interest. The establishment of an effective independent central bank would minimize the chances of political influences which compromise on the effectiveness of Fed. (Baumol and Blinder, 2008).
Identify and explain at least three ways that the Federal Reserve affects the banking system through open market operations (OMO).
As earlier noted, Fed uses the OMO monetary tool where US treasury and federal agency securities are traded to regulate the money supply in the economy. Buying of federal treasury and agency security is done when the aim of Fed is to reduce the money supply in the economy while selling increases money supply thus used in recessionary times. There can be permanent as well as temporary changes to Fed reserves when outright sales or purchases are made. A system repurchase method can be adopted to impose temporary changes.
Fed purchases government bonds from the public which increases the reserves of the commercial banks after it pays for them. Purchasing such reserves sees the banks increase their reserves in an amount equal to what has been paid for the reserves. The same case happens when reserves has been purchased from the public.
Fed can also sells government securities that are not being used to the commercial banks as well as the general public hence surrendering the securities to the banks or general public who can then draw checks against the deposits made. Through this approach Fed reduces the amount of money supply that is available for the commercial banks which also translates to reduced money supply in the entire economy. (www.federalreserve.gov).
Purchasing of government bonds by Fed leads to the reduction of interest rates which encourages banks and households to dispose their reserves to Fed. The selling of such bonds lowers the prices of bonds while increasing the interest rates to make the bonds attractive to the general public as well as the commercial banks.
Fed also purchases or sells the treasury bonds or bills which affect their deposits by increasing or decreasing in size. This also affects the volume as well as growth of banks by allowing them to have increased reserves at their disposal thus more to lend to both commercial banks as well as households. This leads to their increased growth as they make earnings through the interest charged. The OMO also affects the lending processes as it affects the interest rates which are attached to the bank borrowings and loans. OMO regulates the money supply in an economy by either increasing it or decreasing it. (McConnell and Brue, 2004).
Explain how changes in reserve requirements and the discount rate affect the operations of banks and other depository institutions.
The discount rates are monetary policy tools that can be used by Fed to influence the money supply and demand in the economy with the aim of influencing economic growth. Discount rates or discount widow can be defined as the rates charged by Fed to commercial banks which in turn affects the amount of money such banks or financial institutions have thus their lending capacity. The major types of the depository windows by Fed are the primary, secondary and seasonal credits which have varying interest rates. (www.federalreserve.gov).
The discount rates attached to primary credit are generally higher than those attached to other short term discounts in the market. Interest rates charged on secondary credit are also higher than the primary credit interest rate while the seasonal credit discount rates are the average of selected market rates. When Fed increases the discounts rates it discourages commercial banks from borrowing money from it but a reverse effect is felt when the discount rates are lowered.
The amount of money in an economy is increased when banks are encouraged to borrow funds from the Federal Reserve. The reserve requirement refers to the amount of money or funds that financial institutions are expected to deposit with Fed against their securities. The amount set as reserve requirement is determined by the board of governors of Fed as guided by the American law and it is held in terms of vault cash.
Increasing the reserves requirement rates leads to increased required reserves of what the financial institutions are expected to keep with the Fed and this translates to reduced ability to lend money to both banks as well as household thus reducing the money supply in an economy. The reserve is also true. (www.federalreserve.gov).
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