FINM06-18 - Monetary Policy & Central Banking

FORIO, GINALYN F.
Module 3 Assignment

1. Among the monetary policy tools being used by a central bank which is the most widely used and
why? Explain your answer.

Answer:

The most commonly used tool of monetary policy is open market operations. Open market
operations take place when the central bank sells or buys U.S. Treasury bonds in order to influence
the quantity of bank reserves and the level of interest rates. The specific interest rate targeted in
open market operations is the federal funds rate. Open market operations are when central
banks buy or sell securities. These are bought from or sold to the country's private banks. When the
central bank buys securities, it adds cash to the banks' reserves. That gives them more money to
lend. When the central bank sells the securities, it places them on the banks' balance sheets and
reduces its cash holdings. The bank now has less to lend. A central bank buys securities when it
wants an expansionary monetary policy. It sells them when it executes contractionary monetary
policy. The use of open market operations as a monetary policy tool ultimately helps the Fed pursue
its dual mandate—maximizing employment, promoting stable prices—by influencing the supply
of reserves in the banking system, which leads to interest rate changes.

2. Discuss how does Open Market Operations (OMO) work in bringing down inflation .

Answer:

An Open Market Operation or OMO is merely an activity performed by the central bank to either
give or take liquidity to a financial institution or a group of financial institutions and the aim of
OMO is not only to strengthen the liquidity status of the commercial banks but also to take surplus
liquidity from them.

The major target of these operations is interest rates and inflation. The central tries to maintain inflation at
a certain range so that the economy of the country grows at a stable and steady pace. This is taken by the
central bank has a close relation with interest rates. When the central bank offers securities and government
bonds to other banks and the public it affects the supply and demand of credit as well.

The buyers of the bonds deposit the money from their account to the central bank’s account thereby
decreasing their own reserves. With the commercial banks buying such securities they will have less money
to lend to the general public thus reducing their credit creation capacity. Thereby, impacting the supply of
credit.

When the central bank sells the securities, there is a decrease in the price of the bonds and since bond prices
and interest rates are inversely related, the interest rates rise. As the interest rates rise, there is a decrease in
demand of credit.

With the decrease in supply and demand for credit due to fewer reserves and high-interest rates,
consumption reduces thus reducing inflation. When the central bank buys the securities the cycle is
reversed, inflation rises and interest rates decrease.