Term Paper: Open Market Operations

Pages: 4 (1448 words)  ·  Bibliography Sources: 1+  ·  Level: College Senior  ·  Topic: Economics  ·  Buy This Paper

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[. . .] The third tool of monetary control is discount operations: the discount rate is the interest rate charged to U.S. commercial banks (along with other depository institutions) when those institutions borrow reserve funds from a Federal Reserve Bank in their region (there are 12 Federal Reserve Banks spread throughout the country). (Each Federal Reserve Bank has a board of 9 directors, chosen from outside that bank's employee roster.) (Where do earnings from the Federal Reserve Banks go? After expenses are paid, the Federal Reserve Bank gives its remaining profits to the U.S. Treasury. Nearly 95% of the Reserve Banks' net earnings have been paid into the Treasury since the Federal Reserve System began in 1914.)

Secondly, as to why, historically, the Fed prefers open market operations as its main tool of conducting monetary policy: when the Fed buys securities, bank reserves go up, and when the Fed sells securities, bank reserves then go down. With such a hands-on, action / reaction formula in place, and the crucial need for the central bank to regulate the supply of money and promote favorable conditions in the financial sector of our society, there seems no logical reason to abandon open market operations.

III) Why the Fed does not utilize reserve requirements or the discount rate as part of its strategy.

First of all, according to Kaufman's book (Chapter 25, pp. 98), "The Fed does not change reserve requirements frequently..." because "...even a small fraction, say 1/4 of one percentage point, will produce a large dollar change in deposits." And, Kaufman continued, changes of less than one-fourth of one percentage point "are considered unnecessarily confusing..." To banks. Additionally, a minority of banks actually belongs to the Federal Reserve System, and increases in reserve requirements might put member banks at a disadvantage relative to non-member banks. Why? It would force member banks to hold "additional non-earning assets," in Kaufman's words.

And as to why the Fed does not use discount rates very frequently, Ritter's book (Chapter 4, pp. 47-48) notes that the Fed "...generally frowns on..." banks borrowing too much from the discount window, in order to make more loans, and more profit. Even if the Fed lowers the discount rate, banks won't necessarily borrow more money from the Fed unless those banks really need more reserves. "...Since the initiative [to borrow] still rests with the banks rather than with the Fed, the discount process is not a very efficient instrument for the Federal Reserve to use in injecting or withdrawing reserves when it wishes to do so."

IV) Strengths and weaknesses of the three tools of monetary policy / Conclusion

In this paper, the discount rate, reserve requirements, and the open market operations have been discussed pretty thoroughly. Their weaknesses (in III) have been pointed out. Their strengths? When the Fed needs to encourage banks to borrow, and hence increase the money supply, it may, if it deems appropriate, lower the discount rate, and alter the reserve requirements, short-term. Hence, the strength of those systems is that they are there as tools, when needed. They are there, in times when the economy needs a little tweaking or boosting. For the open market operations, "They are flexible...[and] may be reversed quickly if conditions change unexpectedly," Kaufman points out on page 404. "Purchased in the morning can be reversed by sales in the afternoon." Change is one of the things Americans must be prepared for (particularly since 9/11/2001 - one notes, speaking of change, that the cover of Ritter's book is a photo of one of the twin towers of the World Trade Center). Therefore, the American monetary system must be operated from a position of strength - meaning, having solid systems in place that keep money flowing and also anticipate unexpected changes.

Bibliography

Akhtar, M.A. Open Market Operations. New York: Federal Reserve Bank of New York, 1997.

Edwards, Cheryl L. "Open Market Operations in the 1990s." Federal Reserve Board's Division of Monetary Affairs, 2000.

Fisher, Peter R. "Highlights of Domestic Open Market Operations 1998." Federal Reserve Bank of New York, 1999.

Kaufman, George G. The U.S. Financial System: money, markets, and institutions. New Jersey: Prentice-Hall, 1980.

Ritter, Lawrence S., and Silber, William L. Principles of Money, Banking, and Financial Markets. New York: Basic Books, 1974.

The Federal Reserve Board. "Monetary Policymaking,… [END OF PREVIEW]

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"Open Market Operations."  Essaytown.com.  December 17, 2002.  Accessed June 15, 2019.
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