Question

Explain in detail

Pre-2008 Policy Tools

1. required reserve ratio

2. discount rate

3. open market operations

Answer 1

1. Required reserve ratio

* A required reserve ratio is the minimum ratio of cash reserves to deposits that the central bank requires commercial banks to hold

* The bank can hold more than the required cash resources but they cannot hold less .lf they hold less,they immediately borrow cash from Central Bank to restore their required reserve ratio.

* A reseve requirement act like a tax on banks by forcing them to hold a higher part of their total assets as bank reserves and lower part as loans .The the lower part, that is loans are the source of earning higher interest rates

* For example, assumed that Fed's required reserve ratio is 10 percent . A commerical bank has a checkable deposits 50 million dollar, then the commercial bank will have to keep 50*(10/100) = 5 million as required reserves. Potential loan balances help in vault cash or on deposit with the fed in excess of required reserves are called requirements reserves.

* When there are inflationary pressure in the economy, central bank raises required Reserve ratio so that excess reserves held by the commercial banks is reduced and their credit creation capacity is lowered.

* On the other hand, when there are deflationary pressures in the economy , central bank reduces the required reserve ratio so that banks have more excess reserves and credit creation is Increased.

2) Discount rate

* The discounted rate is the interest rate is that Central Bank charges when the commercial banks want to tomorrow money .The discount rate is also called as Bank Rate or Minimum Lending Rate (MLR) .

* Bank have to balance the interest rate they will get all extra lending with the dangers and the costs involved in it if there is a sudden flood of withdrawal which may push their cash reserves below the critical 10%.

* In short, discount rate refers to the interest rate that central bank charges the depository institutions that borrow reserves from it; it's the interest rate charged on discount loan. Discount loan means a loan that central bank makes to a commerical bank.

* A fluctuation in discount rate is capable of causing a ripple down effect as it impacts every sector of a country's economy.

* If Fed wants to increase the money supply ; it can drop the discount rate below the federal funds rate ( the interest charged in the Federal funds market; the interest rates banks charge one another to borrow reserves.) For example, assume that federal funds rate is 5 %. All fed has to do is to set the discount rate at,say,3 percent. Now a bank which needs reserves will have an incentive to go to Fed instead of another banks . The fed gives the bank one million discount loan by increasing the bank's reserves account by 1 million. With more reserves, the bank can create more loans, as a result, money supply will increase.

* Similarly, if Fed wants to reduce money supply ( during periods of inflation) , it will raise the interest rate.

* However, discount rate can't be used to control the money supply with great precision, because it's effects on banks' demand for reserves are uncertain.

3) open market operations

* Open market operations refers to the buying and selling of securities in the open market by the Central Bank.

* Its widely known as the ' bread and butter' instrument of Federal Reserve's policy.

* decisions about the open market operations are made by the Federal Open Market Committee or FOMC which meats every six weeks and during emergencies.

* To increase the money supply, the fed directs the New York fed to buy us bonds . This is called an open market purchase.

* To reduce the money supply, the New York Fed is directed to carry out an open market sale.

* In short, a central bank sells securities to control inflation and purchases securities to control deflation.

* Open market operations are relatively easy to carry out.They require no change in laws or regulations and can be executed in any amount-large or small-chosen by the Fed.

* Their simplicity and ease of use makes them a tool of choice for the Fed.