DISCOUNT RATE AND OPEN MARKET OPERATIONS

admin — Fri, 27 Jun 2008 11:36:40 +0000

The most commonly used central bank tools are those of adjusting the discount rate, to affect the price of money, and buying and selling government bonds, to affect the level of money supply. The discount rate is the rate at which banks can borrow from the central bank. In practice the transmission mechanism is often through the interbank market. The Federal Funds rate, for example, is the rate at which US banks with cash and deposits with Federal Reserve banks in excess of their reserve requirements will lend to banks that have a shortfall:
Discount window. Banks that regularly borrow from the central bank will ﬁnd themselves being charged punitive rates. The discount window provides a mechanism for the central bank to inﬂuence the level of shor t-term interest rates through its role as the lender of last resort. Their ability to inﬂuence rates at the long end of the yield curve is more limited. The use of the discount window is highly visible.
Open market operations. The ﬁnal way in which central banks can inﬂuence money supply is through open market operations. If the central bank wishes to increase money supply then it intervenes to buy government securities. It does this by “printing” cash. If it wants to reduce money supply then it sells government securities. The effectiveness of open market operations is due to the effect of the money multiplier. The central bank has a very long lever.
The central bank can choose the term of the securities it buys or sells and while its effectiveness is limited in can inﬂuence yields at a particular maturity. Its action in terms of money supply and its impact at the short end enjoy considerable leverage but as just one more participant in bonds at a par ticular term it has no such gearing.

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DISCOUNT RATE AND OPEN MARKET OPERATIONS