Financial Institutions Management: A Risk Management Approach 10th Edition by Anthony Saunders Solu

 
38.   Which of the monetary tools available to the Federal Reserve is most often used? Why?   
 
The Federal Reserve uses mainly open market operations to implement its monetary policy. Adjustments to the discount rate are rarely used because it is difficult for the Fed to predict changes in bank discount window borrowing when the discount rate changes and because in addition to their effect on the money supply, discount rate changes often have great effects on the financial markets. Further, because changes in the reserve requirements can result in unpredictable changes in the money base (depending on the amount of excess reserves held by banks and the willingness of the public to redeposit funds at banks instead of holding cash (i.e., they have a preferred cash-deposit ratio)), the reserve requirement is rarely used by the Federal Reserve as a monetary policy tool. The unpredictability comes from at least two sources. First, there is uncertainty about whether banks will actually convert excess reserves (created from a decrease in the reserve requirement) into new loans. Second, there is uncertainty about what portion of the new loans will be returned to depository institutions in the form of transaction deposits. Thus, like the discount window rate, the use of the reserve requirement as a monetary policy tool increases the probability that a money base or interest rate target set by the FOMC will not be achieved.
 
39.   Describe how expansionary activities conducted by the Federal Reserve impact credit availability, the money supply, interest rates, and security prices. Do the same for contractionary activities.
 
Expansionary Activities: We described three monetary policy tools that the Fed can use to increase the money supply. These include open market purchases of securities, discount rate decreases, and reserve requirement decreases. All else constant, when the Federal Reserve purchases securities in the open market, reserve accounts of banks (and thus, the money base) increase. When the Fed lowers the discount rate, this generally results in a lowering of interest rates in the economy. Finally, a decrease in the reserve requirements, all else constant, results in an increase in reserves for all banks.  In two of the three cases (open market operations and reserve requirement changes), an increase in reserves results in an increase in bank deposits and assets. One immediate effect of this is that interest rates fall and security prices to rise. In the third case (a discount rate change), the impact of a lowering of interest rates is more direct. Lower interest rates encourage borrowing. Economic agents spend more when they can get cheaper funds. Households, business, and governments are more likely to invest in fixed assets (e.g., housing, plant, and equipment). Households increase their purchases of durable goods (e.g., automobiles, appliances). State and local government spending increases (e.g., new road construction, school improvements). Finally, lower domestic interest rates relative to foreign rates can result in a drop in the (foreign) exchange value of the dollar relative to other currencies. As the dollar’s (foreign) exchange value drops, U.S. goods become relatively cheaper compared to foreign goods. Eventually, U.S. exports increase. The increase in spending from all of these market participants results in economic expansion, stimulates additional real production, and may cause inflation to rise. Ideally, the expansionary policies of the Fed are meant to be conducive to real economic expansion (economic growth, full employment, sustainable international trade) without price inflation. Indeed, price stabilization can be viewed as the primary objective of the Fed.
 
Contractionary Activities: We also described three monetary policy tools that the Fed can use to decrease the money supply. These include open market sales, discount rate increases, and reserve requirement increases. All else constant, when the Federal Reserve sells securities in the open market, reserve accounts of banks (and the money base) decrease. When the Fed raises the discount rate, interest rates generally increase in the open market. Finally, an increase in the reserve requirement, all else constant, results in a decrease in excess reserves for all banks.  In all three cases, interest rates will tend to rise. Higher interest rates discourage credit availability and borrowing. Economic participants spend less when funds are expensive. Households, business, and governments are less likely to invest in fixed assets. Households decrease their purchases of durable goods. State and local government spending decreases. Finally, a decrease in domestic interest rates relative to foreign rates may result in an increase in the (foreign) exchange value (rate) of the dollar. As the dollar’s exchange rate increases, U.S. goods become relatively expensive compared to foreign goods. Eventually, U.S. exports decrease. The decrease in spending from all of these market participants results in economic contraction, (depressing additional real production) and causes prices to fall (causing the rate of inflation to fall).