.. on of its own while the national economy is prosperous. But the Fed can not concentrate its efforts to expand the weak region for two reasons. First, monetary policy works through credit markets, and since credit markets are linked nationally, the Fed simply has no way to direct stimulus to any particular part of the country that needs help. Second, if the Fed stimulated whenever any state had economic hard times, it would be stimulation much of the time, and this would mean higher inflation. The Fed can not control inflation or unemployment directly; instead, it influences them indirectly, mainly by raising or lowering short-term interest rates.
The major tools the Fed uses to affect interest rates are open market operations and the discount rate, both of which work through the market for bank reserves. Banks and other depository institutions are legally required to hold a specific amount of funds in reserves. Currently, banks must hold 3-10% of the funds they have in interest bearing and non interest bearing checking accounts as reserves. The amount of reserves a bank has to hold changes daily. When banks need additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need.
These loans take place in a private financial market called the federal funds market. The interest rate on the overnight borrowing or reserves is called the federal funds rate or simply the funds rate. It adjusts to balance the supply of and demand for reserves. The interest rate is also used as an indicator of monetary policy and future economic growth (Sims 250). The prime tool the Fed uses to affect the supply of reserves in the banking system is open market operations.
This means the Fed buys and sells government securities on the open market. These operations are conducted by the Feds open market trading desk at the Federal Reserve Bank of New York. If the Fed wants the funds rate to fall it buys government securities from a bank. The Fed then pays for the securities by increasing that banks reserves. As a result, the bank now has more reserves than it is required to hold. So the bank can lend these excess reserves to another bank in the federal funds market.
Thus, the Feds open market purchase increases the supply of reserves to the banking system, and the funds rate falls. When the Fed wants the rate to rise it does the reverse by selling government securities. The Fed gets the payment in reserves from banks, which lower the supply of reserves in the banking system, and funds rate rises (Segalstad 1). Banks also borrow reserves from the Fed at their discount windows, and in that case the interest rate they must pay on this borrowing is called the discount rate. The total quantity of discount window borrowing is called the discount rate (World 68). The discount rate plays a role in monetary policy because, traditionally, changes in the rate may have signaled to markets a significant change in monetary policy.
A higher discount rate can be used to indicate a more restrictive policy, while a lower rate may signal a more expansionary policy. Therefore, discount rate changes are sometimes coordinated with FOMC decisions to change the funds rate (Rukeyser 114). A final tool of monetary policy are foreign currency operations. Purchases and sales of foreign currency by the Fed are directed by the FOMC, acting in cooperation with the Treasury, which has overall responsibility for these operations. The Fed does not have targets, or desired levels, for the exchange rate. Instead, Fed intervention aims to counter disorderly movements in foreign exchange markets. Intervention operations involving dollars, whether initiated by the Fed, the Treasury, or by a foreign authority, are not allowed to alter the supply of bank reserves or the funds rate.
The process of keeping intervention from affecting reserves and the funds rate is called the sterilization of exchange market operations. These are not used as a tool of monetary policy. The Point of implementing policy through raising or lowering interest rates is to affect peoples and firms demand for goods and services. For the most part, the demand for goods and services is not related to the market interest rates quoted on the financial pages of newspaper, known as nominal rates. Instead, it is related to real interest ratesnominal interest rates minus the expected rate of inflation.
Monetary policy can affect real interest rates in the short run. Changes in real interest rates affect the publics demand for goods and services mainly by altering four things: borrowing costs, the availability of bank loans, wealth of households and businesses, and foreign exchange rates. Lower real rates and a healthy economy may increase banks willingness to lend to businesses and households. This may increase spending, especially by smaller borrowers who have few sources of credit other than banks. Lower real rates make common stocks and other such investments more attractive than bonds another debt instruments; as a result, common stock prices tend to rise.
Households with stocks in their portfolios find that the value of their holdings has gone up, and this increase in wealth makes them willing to spend more. In the short run, lower real interest rates in the US also tend to reduce the foreign exchange value of the dollar, which lowers the prices of the exports sold abroad and raises the prices of foreign produced goods. Expansionary monetary policy also raises aggregate spending on US produced goods and services by improving the balance of trade. A monetary policy that constantly attempts to keep short-term real rates low can lead to high inflation and higher nominal interest rates to protect the purchasing power of the funds due to them. This is the reason that economic activity can not keep expanding beyond its potential level. Initially, the low real interest rates will cause business and households to increase their borrowing demands, and that will push up other longer-term interest rates.
These tighter credit conditions will tend to cause real interest rates to rise despite the Feds attempts to keep them low, thereby slowing economic activity, moving it back toward its potential level (Eisner 25). The precise magnitude and timing of the effects of the Feds actions on the economy are never perfectly predictable. This is partially because the future course of the economy is subject to many influences beyond the Feds control, such as government taxing and spending policies, the availability of natural.