1 Open Market Operations
The Fed conducts open market operations by buying
and selling US government securities–especially US Treasury bills. Since the
market for US Treasury bills is so active, the Fed can make large purchases and
sales quickly and easily, without disrupting the market. Although the FOMC
makes decisions on how open market operations are to be conducted, the trades
themselves are executed at the Open Market Desk at the Federal Reserve Bank of
Open market purchases and sales
have permanent affects on the monetary base, but sometimes the Fed will want to
change the monetary base only temporarily. At these times,
it engages in two other types of
Repurchase Agreement (repo) = The
Fed purchases US government securities will an agreement that the seller will
buy them back (repurchase them) at a specified price on a specified date,
usually within two weeks. A repo is therefore like a temporary open market
purchase, temporarily increasing the monetary base.
Matched Sale-Purchase Transaction
(reverse repo) = The Fed sells US government securities with an agreement that
the buyer will sell them back at a specified price on a specified date, again
usually within two weeks. A reverse repo is therefore like a temporary open
market sale, temporarily decreasing the monetary base.
Hence, in conducting monetary
policy, open market operations have a number of advantages:
They are under the direct and complete control
of the Fed.
They can be large or small.
They can be easily reversed.
They can be implemented quickly.
2 Discount Loans
When a bank receives a discount
loan from the Fed, it is said to have received a loan at the
“discount window.” The Fed can
affect the volume of discount loans by setting the discount rate:
A higher discount rate makes
discount borrowing less attractive to banks and will therefore reduce the volume
of discount loans.
A lower discount rate makes
discount borrowing more attractive to banks and will therefore increase the
volume of discount loans.
Discount lending is most
important during financial panics:
When depositors lose confidence
in the financial system, they will rush to withdraw their money.
This large deposit outflow puts
the banking system in great need of reserves. The Fed stands ready to supply
these reserves by making discount loans. In such situations, the Fed acts as a
lender of last resort. Hence, in October 1987 and again in September 2001, the
Fed made it clear that it would supply additional reserves to the financial
system, as necessary, through the discount window.
Advantage of discount loans:
They allow the Fed to act as a lender of last
resort during a financial panic.
Disadvantages of using discount
loans as a tool for monetary policy during normal times:
The volume of discount loans can be influenced
by the Fed, but not completely controlled:
The Fed cannot be sure how many banks will
request discount loans at any given interest rate.
Changes in the discount rate must be proposed by
the Federal Reserve Banks before being approved by the Board of Governors.
Hence, they are neither quickly made nor easily reversed.
3 Changes in Reserve Requirements
By affecting the money multiplier, changes in the required reserve
ratio can lead to changes
in the money supply.
Disadvantages to using changes in reserve requirements as a tool for
Large changes in reserves must be approved by
Hence, large changes cannot be made quickly and
Also, if a bank holds only a
small amount of excess reserves and the required reserve ratio is increased,
the bank will have to quickly acquire reserves by borrowing, selling
securities, or reducing its loans. Each of these three options is costly and
disruptive. Hence, changes in reserve requirements can cause problems for banks
liquidity management more difficult.