Question

2) Explain how the Fed carries out open market operations. How does this change the money supply? How is the Fed Funds rate an indicator of this action?

Answer 1

OPEN MARKET OPERATIONS BY THE FED

DISCOUNT RATE,RESERVE REQUIREMENTS AND OPEN MARKET OPERATIONS ARE THE THREE TOOLS USED BY THE FED TO IMPLEMENT AND CONTROL THE MONETARY POLICY.OPEN MARKET OPERATIONS ARE MOST FREQUENTLY USED AS THEY ARE FLEXIBLE AND EASY TO IMPLEMENT.

THE BUYING OR SELLING OF GOVERNMENT SECURITIES IN THE OPEN MARKET IN ORDER TO INCREASE OR DECREASE THE MONEY SUPPLY IN THE BANKING SYSTEM IS KNOWN AS OPEN MARKET OPERATIONS.THE FED OPEN MARKET COMMITTEE(FOMC) IS A COMMITTEE APPOINTED BY THE FED,SO AS TO ENACT ITS MONETARY POLICY.THE FOMC SETS A FEDERAL FUNDS RATE AND THEN IMPLEMENTS OPEN MARKET OPERATIONS OR THE OTHER TOOLS OF THE MONETARY POLICY TO MEET THE TARGET FUNDS RATE.THE FEDERAL FUNDS RATE IS THE INTEREST RATE BANKS CHARGE TO EACH OTHER FOR THE OVERNIGHT LOANS TO MEET THEIR RESERVE REQUIREMENTS.THE FED OBTAINS THE TARGET FUNDS RATE BY ENACTING AN EXPANSIONARY OR CONTRACTIONARY MONETARY POLICY

EXPANSIONARY MONETARY POLICY IS IMPLEMENTED WHEN THE FED WANTS TO REDUCE THE FEDERAL FUNDS RATE AND INCREASE SUPPLY OF MONEY.THE FED PURCHASES GOVERNMENT SECURITIES AND PAYS FOR THEM TO THE ACCOUNT MAINTAINED AT THE FED BY THE PRIMARY DEALERS BANK.THIS CASH DEPOSITED ADDS TO THE CASH THAT COMMERCIAL BANKS HOLD AND THUS INCREASE THEIR LENDING CAPACITY.WHEN AMOUNT OF FUNDS AVAILABLE TO LOAN INCREASES INTEREST RATES COME DOWN AND BORROWING BECOMES CHEAPER.

CONTRACTIONARY MONETARY POLICY IS IMPLEMENTED WHEN THE FED WANTS TO INCREASE THE FEDERAL FUNDS RATE AND REDUCE SUPPLY OF MONEY.THE FED SELLS GOVERNMENT SECURITIES WHICH DECREASES THE AMOUNT OF MONEY LEFT WITH THE BANK AND THUS REDUCES THEIR LENDING CAPACITY.THIS DECREASE IN THE AMOUNT OF FUNDS INCREASES THE INTEREST RATE AND BORROWING BECOMES COSTLY.

HOW IS THE FED FUNDS RATE AN INDICATOR OF THIS ACTION

AN INCREASE IN THE FED FUNDS RATE INDICATES REDUCED MONEY SUPPLY IN THE MARKET,WHICH LEADS TO HIGHER INTEREST RATE.IN THIS SITUATION MARKET EQUILIBRIUM LEVEL OF SUPPLY AND DEMAND FOR MONEY IS LOWERED.(CONTACTIONARY MONETARY POLICY)

A DECREASE IN FEDS FUNDS RATE INDICATES INCREASED MONEY SUPPLY IN THE MARKET,WHICH LEADS TO LOWER INTEREST RATE.IN THIS SITUATION MARKET EQUILIBRIUM LEVEL OF SUPPLY AND DEMAND FOR MONEY IS INCREASED.(EXPANSIONARY MONETARY POLICY)

THE FEDERAL FUNDS RATE RESPRESENTS THE INTEREST RATES CHARGED BY THE LENDING INSTITUTION.