Countries, like businesses, control their economic positions to maintain a healthy economic stance regarding their financial resources.
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Often, the nations establish their respective central banks that act as the finance department in the country to regulate both the money, as well as the credit system.
The central banks use varied policy tools, including bank reserves, federal funds market, open market operations, discount rates, and foreign currency operations, to achieve their objectives of maximum employment and stable price levels, among other goals (Rose & Marquis, 2003, p. 64).
This paper seeks to discuss how such available policy tools are used by these institutions to determine the nation’s policies regarding money and credit.
The paper further highlights some of the weaknesses, as well as strengths of these monetary policy tools. It also gives an insight on how a country’s economic goals are affected by the policy actions implemented by their central banks.
Banks often maintain a specific amount of funds as reserves for purposes of meeting their unexpected outflows (Gamber & Colande, 2006, p. 78). These reserves are maintained as cash or as deposits mainly with the central bank.
Typically, the banks hold a larger amount in their reserves than is required for purposes of clearing overnight checks, restocking their automated cash machines (ATMs), and making different payments.
The reserve held by a given bank determines the amount of money that the same bank can lend.
The central bank’s Board of Governors sets the reserve requirement in any country and it forms a critical aspect of the national monetary base (Gamber & Colande, 2006, p. 78).
This monetary tool influences policies in the sense that the treasury, which is the most important supplier of high-powered money, writes cheques on its account at the central bank to increase the reserve balance.
On the other hand, the treasury’s act of collecting taxes diminishes the reserve levels in the bank (Arestis & Sawyer, 2006, p. 79). This is critical because it highlights the fact that a country’s fiscal policy is by all means tied to the reserve balances.
The central bank uses the bank reserve tool to defend the nature and position of the economy because of the discretionary nature of the treasury operations (Arestis & Sawyer, 2006, p. 79).
The Federal Funds Market
The federal funds market relates to the bank reserves as a policy tool used by central banks to regulate a country’s economy. Banks use this market to borrow and lend their reserve levels.
It often occurs that some banks may have more deposits in their reserves than it is required by the central bank (Strumeyer, 2012, p. 118). On the other hand, banks may find themselves in need of money to maintain their reserves at the right level as expected by the central bank.
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Banks are incentivised to lend out the reserves because reserve accounts do not attract any interest.
Thus, other depository institutions needing additional funds for their reserves can borrow from banks holding the excess amount. The short term lending is facilitated by the federal funds market (Strumeyer, 2012, p. 118).
The central bank, acting on instructions from banks with reserve accounts, switches these funds from the lending to the borrowing bank (Strumeyer, 2012, p. 118). A funds rate, which is the interest rate paid by the borrowing bank, is the most critical aspect as far as the money market is involved.
The funds rate is set by the central bank, but consideration is given to the interplay of the market forces, mainly the demand and supply levels, to fix it.
The federal funds market, therefore, is an important monetary tool that helps in determining the monetary policy because both the current and future interest rates in the economy are anchored upon the funds rate (Strumeyer, 2012, p. 118).
Open Market Operations
The ‘open market operations’ is the most important tool that central banks use in the determination of their monetary and credit policies. This tool influences the reserves’ supply within the banking system.
The central bank purchases and sells securities belonging to the government on the open market, including bankers’ acceptances (Thomas, 2006, p. 398).
The central bank has the discretion to determine the timing and magnitude of the transactions and implement the open market purchases basing on the needed impact on bank reserves, short-term interest rates, monetary aggregates, and the monetary base (Thomas, 2006, p. 398).
The central banks use their portfolio of securities to earn their interest income. In this regard, the total revenue that the central bank earns varies proportionally to the central bank’s portfolio magnitude (Thomas, 2006, p. 399).
For instance, a monetary restraint policy will be the central bank’s best alternative to counter the situation where an economy experiences escalating inflation and excessive aggregate expenditures (Thomas, 2006, p. 399).
Such a condition will see the institution sell its securities within the open market. New reserves will be created to pay for the securities, where the security dealers’ reserve account will be credited.
This mechanism allows the market operations tool to govern both the bank reserves’ behaviour and the monetary stand.
As Thomas (2006, p. 399) points out, the action by the central bank in terms of acquisition or sale of securities results in the multiple expansion of deposits or contraction, thereby affecting the monetary aggregates in general.
The discount rate is considered as a general or a quantitative instrument that influences the volume of credit that circulates in an economy. The central bank uses this rate to purchase or rediscount the bills of exchange, including other commercial papers appropriate for purchase.
Banks borrow funds from the central bank by way of rediscounting the bills or through lending based on security on similar bills (Fernando, 2011, p. 560). Alternatively, lending by the central bank may also take place by way of short-dated government papers.
The discount rate is determined solely by the central bank on a weekly basis and the banks alter it whenever the government seeks to achieve a particular desirable objective.
For instance, the central bank may raise the discount rate as a move to discourage borrowing within the economy. Such a move, therefore, tightens credit because only a few individuals may be in a position to afford the high interest rates (Fernando, 2011, p. 560).
On the other hand, the central bank lowers the discount rate when the government wishes to encourage more borrowing, making it cheaper for individuals to borrow and service their loans.
The central bank uses this tool to regulate the actions of the commercial banks, thus controlling undue expansion of credit (Fernando, 2011, p. 560).
Foreign Currency Operations
The modalities of the foreign currency operations work in a similar manner as those of the open market operations. However, the main differentiating aspect of the two is the fact that the main commodity sold is the foreign currency, instead of the government securities.
The central bank purchases foreign currencies as a way of expanding a country’s monetary base, thus influencing its money supply (Rose & Marquis, 2003, p. 118).
This move, in turn, creates additional reserves within the banking system. Thus, the central bank influences its ability to lend and re-lend its financial base to other institutions in the country (Marthinsen, 2008, p. 248).
The bank, however, may also choose to decrease monetary aggregates in the economy, especially if they affect the economy negatively, by selling the foreign currencies.
Such a move helps the bank to lower the amount of reserves in circulation, thereby compelling other financial intermediaries to limit their loans. This tool helps countries that are less developed, which mainly suffer from underdeveloped security markets (Marthinsen, 2008, p. 248).
The foreign currency trade offers a better alternative to create the requisite influence since such countries are unable to purchase or trade their respective government securities easily or in large amounts.
Strengths and Weaknesses
The reserve requirements enable a government to regulate prices stability within the economy (Welch & Welc, 2010, p. 248). The economy is at risk of suffering from inflation as a result more people having more money than the demand when too much money is in circulation.
Thus, the central government may raise the reserve requirement amount to restrict the amount of money in circulation.
On the other hand, short supply of money may result in prices shooting up, thus the central bank avoids such a scenario by releasing more money in the reserve system to cushion on the shortage.
Regulating the amount of money supply within an economy may end up affecting the government’s objectives of achieving growth in the long run.
It is not easy to determine the correct amount of money that should be in circulation at any given time because of economic uncertainty (Welch & Welc, 2010, p. 248).
Discount rates provide an avenue through which the government, through the central government, earns additional revenue for maintaining its operations. An improved economy will offer a greater chance for the government to earn more through an expanded discount rate.
Discount rates may result in poor economic performance, especially where external economic factors are not considered. A higher discount rate will discourage borrowing, and affect long-term economic development negatively (Welch & Welc, 2010, p. 248).
A nation’s economic policy is directly tied to the respective policy actions that are determined by its central bank. Such policies employ the use of reserve requirements, which the central bank uses to regulate the total amount of money that circulates within the economy.
Too much money in circulation may result in inflation, leading to a sharp increase in the prices of products. Limited amount in circulation may result in difficulties in the economy where few people would be in the position to afford commodities.
Thus, the central bank ensures that only the requisite amount of money is in circulation, while keeping the extra cash in the reserves.
Another tool of the monetary and credit policy, the discount rate, is equally used by the central bank to determine the flow of funds, mainly loans, in the economy. All commercial banks adhere to this rate, which may result in high or low borrowing in the economy.
A higher rate discourages people and institutions from borrowing loans, while a lower rate encourages more borrowing.
List of References
Arestis, P & Sawyer, MC 2006, A handbook of alternative monetary economics, Edward Elgar Publishing, Cheltenham, UK
Fernando, AC 2011, Business environment, Dorling Kindersley, New Delhi, India
Gamber, E & Colande, DC 2006, Macroeconomics, Pearson Education South Africa, Cape Town
Marthinsen, JE 2008, Managing in a global economy: Demystifying international macroeconomics, Thomson, Mason, OH
Rose, PS & Marquis, MH 2003, Money and capital markets: financial institutions and instruments in a global marketplace, 8th edn, McGraw-Hill, New York, NY
Strumeyer, G 2012, Investing in fixed income securities: understanding the bond market, John Wiley, Hoboken, NJ
Thomas, LB, 2006, Money, banking and financial markets, Thomson, Mason, OH
Welch, PJ & Welc, GF 2010, Economics: Theory and practice, John Wiley, Hoboken, NJ