Macroeconomics
Study Tip In a banking system with limited reserves, traditional tools of monetary policy are used, including OMOs,reserverequirements(rr),andthediscountrate.Inabankingsystemwithamplereserves,on the other hand, OMOsareprimarilyusedtoensuresuffcientreserves,notwiththegoalofaffecting interest rates. Administered interest rates, such as the discount rate and the Interest on Reserves (IOR),becometheprimarytoolsinthisscenario.ThebankingsystemintheU.S.currentlyhasample reserves and relies on IOR as a key policy tool. Open Market Operations (OMOs) OpenmarketoperationsOMOs areoneofthemostcommonlyusedmonetarypolicytools inalimited reserves banking system . It involves the buying and selling of government securities , such as Treasury bonds and bills, in the open market (to banks and individuals). When a central bank buys securities from the market, it injects money into the banking system, increasingthemoneysupply(becausebondholdersreceivemoneyinreturnfortheirbonds).Therefore, the Fed buys bonds or other securities as part of an expansionary monetary policy . Conversely, when it sellsthesesecurities,it withdrawsmoney fromthebankingsystem,reducingthe money supply (because buyers of bonds pay money totheFedwhoholdsitinreturnforbonds).This means that the Fed sells bonds or other securitiesas part of a contractionary monetary policy . ThegoalofOMOsistoinfluenceshort-terminterestrateswhichrepresentnominalinterestratesand,by extension,theoverallcostofborrowingintheeconomy.ByadjustingthemoneysupplythroughOMOs, central banks can encourage or discourage borrowing and spending. OMOs affect money supply in the economy by changing the monetary base. Here’s a step-by-step explanation of how that works: Assume that the Fed buys bonds. As a result: ➔ Bondholdersreceivecashinexchangeforthebondstheysold.Rememberthatabondissueris in fact a borrower, whereas a bondholder is a lender. ➔ Deposits increase allowing for more loans to be created. ➔ The increase in the supply of loans reduces interest rates which encourages frms and households to borrow more. ➔ Consumption increases due to increased borrowing, and more money is deposited into banks. ➔ The monetary base (currency in circulation + bank reserves) increases. ➔ Money supply increases by an amount equal to the money multiplier times the change in reserves: Maximum change in money supply = change in MB × MM. ➔ Nominal interest rate increases following a shift of the Ms curve to the right.
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