Fed and the Economy
For an economy that is in recession, the FED does not directly affect the output and the economy. Rather, it does so in an indirect manner through the lowering of the federal funds rate, which, in most cases is short-term in nature. Open market operations are employed in this case. These are usually meant for the bank reserves, otherwise referred to as the federal funds market. In such a case, it is a requirement that banks have a certain amount or more set aside for reserves (Maxwell, 2003, p.6).
The federal funds market
The amount of reserves a bank wants to hold is bound to vary with the deposits and transactions. In the event that additional reserves are needed within a short while, they are borrowed from other banks with extras reserves. The federal funds market thus becomes the platform for these loan operations. The interest rate accrued because of overnight borrowing of reserves is known as the federal funds rate and is accordingly adjusted depending on the supply and demand of the same.
Open market operations
This is one extremely valuable tool employed by the Fed as far as influencing the supply of reserves is concerned. In this case, it purchases and disposes government securities to the public. The Federal Reserve Bank of New York is often charged with the conduction of these operations. In order to lower the funds rate, the Fed buys government securities from a bank. These are paid for by increasing the reserves of the particular bank. The bank as such ends up having extra reserves, which it can lend to other banks within the federal funds market. In the end, this open market purchase raises the supply of reserves to the banking system, consequently lowering the federal funds rate (Maxwell, 2003, p.6).
On the other hand, to increase the funds rate, the Fed sells government securities. It therefore receives payment from banks in the form of reserves. The supply of reserves in the banking system falls, thereby increasing the funds rate.
The Discount Rate
It is also possible for banks to borrow reserves in a direct manner from the Federal Reserve Bank. This is usually done at their “discount windows”. The rate that financially stable banks are required to pay in this case is what is referred to as the discount rate. The Boards of Directors of the Reserve Banks, depending on the review and determination of the Federal Reserve Board, usually set these rates (Maxwell, 2003, p.6). In the event that an institution is not capable of qualifying for “primary credit”, secondary credit will be offered, which is characterized by higher interest rates with more strict conditions. Right from the beginning of the year 2003, the discount rate has always been 100 basis points higher than the funds rate target, this is despite the fact that the variation between the two rates could shift principally. This helps banks to avoid resorting to this option before using other options, which are cheaper. In addition, the rather ease with which reserves can be gotten at this rate effectively places a ceiling on the funds rate (Maxwell, 2003, p.7).
Foreign Currency Operations
The FOMC, in liaison with the treasury, usually directs the buying and selling of foreign currency by the Fegotted. The Fed, therefore, targets at nothing as far as the exchange rate is concerned (Maxwell, 2003). Contrary to this, it takes part in the curbing of undue movements in foreign exchange markets, which may interfere with the proper functioning of the financial markets. On such a scenario, it is the purchasing of dollars (or otherwise selling the foreign currency) to enhance absorption of the selling pressure when the dollar is unstable. These interventions are usually in most cases barred from changing the supply of bank reserves or funds rate through the sterilization of exchange market operations (Maxwell, 2003, p.7).
Reference
Maxwell, D. (2003). Fed: The Way Forward. The Economic Watch , 6-7.
