Demand and supply are obviously affected by the monetary tools of Fed
Monetary supply is affected by Fed using three main tools. These tools include the rate target for the federal funds, lending practices carried out through discounts and finally, the reserve regulation as stipulated by fiscal laws. To begin with, the supply of reserves is increased by open market purchases (Dodd, 2012). As a consequence, a sharp decline of the federal funds rate is realized or recorded. On the other hand, a rise in the federal funds rate takes place when an open market sale prevails. It is equally vital to mention that reserves can be increased by a rise in discount loans. Therefore, banks will tend to borrow more when the discount rate is averagely low. When the latter action takes place, it triggers a decrease in federal funds rate as well as a significant improvement in the supply of reserves. Surplus reserves must be held by banks owing to a rise in the required reserve ratio. In other words, demand for reserves goes up when the reserve requirement is revised upwards. On the same note, the same scenario triggers a rise in the rate of federal funds (Dodd, 2012).
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When it comes to monetary policy, open market operations play a very crucial role. Both money supply and monetary base are increased by an open market purchase. As a result, the short-term interest rates are lowered. Any category of debt security may be used to carry out open market operations by fed. However, this is only possible in theoretical terms. Treasury securities are practically used on a practical basis owing to the expanse and dynamic nature of this market. Additionally, the nature of this market easily permits the absorption of large financial transactions.
Short term loans and deposits should be handled by banks in an ideal financial market situation. In addition, the credit-worthiness of players are known by banks. However, it is vital to mention that banks act as a link between those who borrow money and those who make deposits (Griffiths, Kotomin & Winters, 2012). Nonetheless, strict regulation prevails. As a result, banks have a lesser cost advantage than money markets. Surplus expenses are incurred by banks compared to money markets due to the reserve requirements. Money markets continue to grow more than banks because banks are strictly regulated especially on how much interest rates they are supposed to charge customers who save funds with them. Such a restriction or regulation is not present in the operations of money markets. For example, any slight rise in interest rates within banks often to a major backlash because customers move their savings to money markets so that they can reap impressive interest rates. As it stands now, the regulatory costs are lower than the much-needed informational advantages.
The money markets also benefit investors more than banking systems. For instance, within a short period, surplus funds can be safely warehoused in money markets but not banks. Better still, temporary low cost funds can be easily sourced from money markets by borrowers. The same scenario is not possible with banks (Dodd, 2012).
The above reasons attempt to explain why money markets are still powerful fiscal instruments that banks will continue to rely on in spite of their vast ability to gather vital financial data.
Dodd, R. (2012). What are money markets? Finance & Development, 49(2), 46-47.
Griffiths, M. D., Kotomin, V., & Winters, D. B. (2012). A crisis of confidence: Understanding money markets during the financial crisis. Journal of Applied Finance, 22(2), 39-59.
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