Money, Banking, and International FinanceThe Fed can do the opposite of a REPO, called the Reverse REPO. The Fed sells securities
to the dealers, and the dealers sell the securities back to the Fed for a specific price and on a
particular data in the future. Thus, the reserve REPO temporarily lowers excess reserves in the
banking system.
The Fed has four reasons why open-market operations are its most popular and important
tool. First, the Fed can completely control how many securities it buys or sells. Second, open-
market operations are very flexible. The Fed can influence bank reserves by a little amount by
buying few U.S. government securities or by a large amount by buying many securities. Third, if
the Fed makes a mistake by buying too many U.S. government securities, then it can turn around
and sell them to correct its mistake. Finally, the Fed can implement open-market operations very
quickly.
Many people scrutinize the Fed, and they read the Fed's directives for its open-market
trading desk. However, these directives are vague and not precise, creating the principal-agent
problem. If the directives are vague, then the outcome does not matter. The Fed can deem any
outcome as a success, making the Fed unaccountable for errors.
Many central banks across the world, including the European Central Bank use open-
market operations similarly to the United States. Although some countries have a small market
for government securities, central banks can buy and sell any assets.
Discount Policy....................................................................................
Fed’s second monetary policy tool is the discount policy. The Fed can grant loans to
financial institutions. For example, a bank experiences financial problems and needs reserves.
Consequently, the bank sells a $10,000 T-bill to the Fed, and the Fed boosts bank’s reserves by
$9,000. The discount is the difference while the T-bill becomes the collateral of the loan.
Eventually, the bank repays the Fed loan, and afterwards, the Fed returns the T-bill for $10,000
to the bank. The $1,000 difference reflects the interest rate the Fed charges for the loan, called
the discount rate. Traditionally, the Fed only loaned to banks that were members of the Federal
Reserve System. Currently, any bank in the U.S. can borrow from the Fed, and the Fed may not
require collateral for the loan.
Each Fed district bank provides loans, known as the “discount window.” Furthermore, the
Fed could use discount policy to influence the money supply and interest rates. For example,
Figure 3 shows the Federal Funds Market, where banks lend their reserves at the Fed to other
banks. Consequently, the banks electronically transfer these funds through the Fedwire. Demand
function constitutes the banks’ demand for federal funds. These banks borrow funds to ensure
they hold enough reserves to meet depositors’ withdrawals or satisfy the Fed’s reserve
requirements. Demand curve is downward sloping because banks borrow more funds if the
interest rate decreases (i.e. the loans are cheaper). Supply function represents the banks’ supply
of federal funds to the market because these banks hold excess reserves. These banks
temporarily lend out excess reserves, so they can earn interest income. Supply function is
upward sloping because banks lend more funds for a greater interest rate (i.e. they earn higher
profits). Intersection of the demand and supply curves determines the equilibrium interest rate
(i) and amount of reserves (R).