Money and banking - Research Paper Example

Despite the government’s efforts to prevent the collapse of the banking system, it did not successfully restore economic growth; the United States entered a deep recession in December 2007 that extended up to June 2009 (Kroszner and Melick 6). FED used the three tools of monetary control: open market operation, reserve requirement, and discount rate to counteract the progression of the financial crisis. Figure 1: The Graph showing the financial crisis between 2007 and 2007 (Source: Gowland 33) The graph above shows that there was constant recession between 2007 and 2009.

Financial recovery began to be experienced as from march 2009. Open market operation The most appropriate monetary policy that was used to counter the financial crisis of 2007-2009 constituted the increase the monetary base. Open market operation (OMO) is an instrument of monetary policy, which involves selling and purchasing of marketable securities (Stock and Mark 11). These transactions are conducted in the open market by the central bank as an instrument of controlling the monetary system.

Open market operations target the cash balances of held by commercial banks and other non-bank financial institutions including their tills and in relation to their excess reserves at the central bank. The central bank sells its holdings of the government securities to commercial banks to reduce excess reserve held by commercial banks. When the central bank anticipates liquidity deficiency, it injects additional liquidity by purchasing from the existing stock of the government securities. Decreasing the monetary base during the 2007-2009 financial crisis involved the reduced supply of credit, which was used to facilitate the adjustments in financial market in order to achieve equilibrium in money demand and supply.

The Federal Reserve had to sell large quantities of securities that were necessary to achieve decreased supply of credit (Stock and Mark 22). Fed would also sold high-quality securities to minimize Fed’s credit risk and the public would be informed that the expansion in the monetary base is temporary; thus, the composition of Federal Reserve’s balance sheet and size of the monetary base would be restored to normal after financial markets and economic activity begin to normalize. The Federal Reserve used the tool of open market operations with an objective of supporting proper functioning of credit markets, reduce the pressure on long-term financial markets and make financial conditions accommodative by selling long-term securities for the Fed’s portfolio.

Figure 2: The Open Market Operations Graph (Source: Stock and Mark 21) i represents the nominal rate of interest, Dm represents money demanded and Ds represents the money supplied. The Federal Reserve varies the rates of interest to ensure maintenance of demand and supply of money with the aim of preventing financial crises. Discount Rate The second tool of monetary control that Fed used during the financial crisis is the discount rate. Under this policy, the bank can borrow reserves from the Federal Reserve at their discount windows (Stock and Mark 18).

These rates are set by the Boards of Directors of the Reserve Banks, but the rates must be subjected to determination and review by the Federal Reserve Board. The Federal Rese