These three tools used by the Fed have an impact on gross domestic, product (GDP), inflation, interest rates, and unemployment. Open-Market Operations The Fed's the most important tool is the open-market operations. The open-market operations deal with buying or selling government bonds to commercial banks or to the public. When the Fed buys bonds from commercial banks, the commercial bank will have negative securities and positive reserves in assets. The positive reserves will increase the lending ability of the commercial banks.
This results in banks lending out their excess reserves which in turn will increase the supply of money. On the other hand, when the Federal Reserve sells securities in the open market to commercial banks or to the public, bank reserves will be reduced and thus the nation’s money supply will decline (McConnell-Brue, 2004, chpt. 15). “The Fed can also manipulate the reserve ratio in order to influence the ability of commercial banks to lend” (McConnell-Brue, 2004, chpt. 15).
There are two forms of monetary policy, expansionary and contractionary policy. In expansionary policy, the Federal Reserve Bank ("Fed") is used to fight unemployment by lowering its interest rates and to increase the supply of money. In order to do this, the Fed will buy securities, lower the reserve ratio or lower the discount rate. Its purpose is to make bank loans less expensive and more available which increases the aggregate demand, output and employment. In contractionary policy, the Fed will try to reduce the aggregate demand by limiting the supply of money as well raising interest rates to fight inflation.
Under a managed float regime, the foreign exchange rate is determined by demand and supply forces in the market but the central bank intervenes when their domestic currency grow too weak or strong. Under unsterilized foreign exchange intervention, the central bank influences the foreign exchange rate by adjusting MB to instigate changes in MS. Increasing MS by buying international reserves induces depreciation of domestic currency whereas decreasing MS by selling international reserves induces appreciation of domestic currency by influencing both nominal domestic interest rate and expectation about future exchange rate. Central banks also engage in a sterilized foreign exchange interventions “when they offset the purchase or sale of international reserves with a domestic sale or purchase. For example, the purchase of $10000 million of international currency by central bank might be sterilized by selling $10000 million worth of domestic government bonds. When engaging in sterilized intervention, there is no net change in MB, therefore long-term effect does not exist on the exchange rate.
The examples of expansionary monetary policy are reduction in reserves, decrease in overall discount rates and purchase of government securities. These are the tools which are used by central banks during recession period. This practice requires the incresse of flow of money in markets thus decreasing the overall interest rates and borrowing costs. When the interest rates are high the central bank promotes the lowering the discount rates. As the interest rates falls the consumer and investor can borrow money more easily and cheaply.
Tools that Control Money Supply The Federal Reserve use several tools like discount rate, federal funds rate, required reserve ratio and open market operations to control the money supply. In the simulation, the effect of controlling the money supply on the economy was presented. Typically, releasing money into the system results in higher Real GDP and lower unemployment. On the other hand, it also raises inflation. Inflation and Real GDP work cross-purposes.
However, Cooper (1974) and Nozar & Taylor (1988) asserted that there is no relation between the money supply and the stock index despite the loosening monetary policy. Tightening Monetary Policy: An increase in interest rate due to this policy usually negatively affects the stock market. First, it raises the operating costs of companies. Second, it reduces the needs of borrowing of investors to stocks. Third, investors are likely to invest in bonds more than stocks, making the liquidity of stocks decrease.
The job to keep it under the control is obviously of a government. Some major are: Controlling Open Market: When the Central bank wants to lower Inflation, they can sell the securities of the government hence decrease the supply of the money. Keeping Money in the central bank: It is the most effective way to control inflation. Although it is very rarely adopted; to fight inflation, the required money to be kept at central bank should increase. Control Interest Rates: The central banks control interest rate through special rates which banks are charged with when they borrow the money from them.
Increasing interest rates and selling securities via open market operations is common one. They use expansionary monetary policy to minimize unemployment and avoid the recession. They bring down the interest rates, purchase securities from member banks, and use other ways to raise the liquidity. There are two types of the monetary policy such as: A. Quantitative measures: Are designed to adjust the volume of credit created by the banking system. It is work through affecting the demand and supply of credit.
3) Changing the discount rate. This article talks about the Fed decreasing the discount rate to stimulate the economy. The discount rate is the rate of interest the Fed charges for loans it makes to banks. An increase in the discount or interest rates makes it more expensive for banks to borrow from the Fed. A discount rate decrease makes it less expensive for banks to borrow.