Question

(a)- Distinguish-between-intermediate target and operating target of monetary policy (-6-marks) (b) Discuss the-major-monetary policy tools used by the- Federal-Reserve of the-USA to-influence money-supply.. (9-marks) (c)- If a-yield-curve-looks-like the-one-shown-below. What-is the-market predicting about the movement of future short-term- interest rate? What might the yield-curve indicate about the market prediction for the inflation rate in the future? (10-marks) Tn to maturt

Answer 1

A) Following are the differences between intermediate targets and operational targets:

1.On the basis of Fed Bank: Control Intermediate targets are not directly in control of Federal Bank. They are only indirectly influenced by Federal Banks Monetary Policy decision. On the other hand Federal Bank can control Operational Targets directly on day to day basis through its monetory Policy tools.

2. Change in targets: Intermediate targets changes to match new Policy decisions and they behave relative to Federal Reserve Banks stated economic goals. On the other hand operational targets shift continually as they guide day to day actions of the Federal Bank.

3. Example: Intermediate Targets are related to Monetary growth or interest rates. Operational targets aim is adjustment in short term, inter-bank interest rates.

B) Monetary Policy tools used by Federal Reserve Bank of USA to influence money supply are as follows:

1.Change in reserve requirements (reserve ratio): As we all know that banks lend its customers deposited money as loan to lenders. Since depositers can take their money back whenever they required,. Fed Bank donot allow banks to lend all deposited money. Banks have to reserve some percentage of deposit and it is known as reserve ratio. This reserve ratio is directed by Fed Banks. Based on the requirements of economy that Fed Bank want it to expand or contract Fed Banks can change reserve ratio. By lowering reserve ratio money supply will increase and by increasing reserve ratio supply will decrease.

2. Change in discount rate: Fed Bank charges interest rates from the banks to borrow additional reserves. These interest rates are also decided by Fed Banks. If Fed Banks wants more money supply it lowers interest rates and if it wants. Less money supply it increases interest rates.

3. Open Market Operations: These operations are based on buying and selling of government securities by Fed Banks of large banks and security dealers. If Fed Bank wants to infuse money in economy, it buys government securities, while if it wants to lower money supply, it sells government securities.

4. Lenders of last resorts: When businesses are risky and Banks are hesitant to lend loans, Fed Bank lend its own reserves to Banks which they can lend to their customers.

C)The curve indicates that initially short term interest rates will increase as yield is increasing. Though, when bond will come closer to term to maturity, these rates will keep falling. Fed bank increases interest rates to bring inflation down. Hence, initially short term inflation rate must be high, that is why Fed Bank plans to increase interest rates to curb inflation rates. Near the maturity term, inflation is expected to go down due to Fed Banks Policy of higher interest rates. Once inflation rate will start falling, Fed Bank will lower short term interest rate as well. Hence, based on curve both short term interest rate and inflation rate will increase initially and then they will start falling when they come closer to term to maturity.

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