Global banking issues - Assignment Example

Monetary Policy Tools There are a number of monetary policy tools that central banks apply to control the money supply or circulation in the economy. The reserve requirement and open market operations are the most common among all monetary tools used by central banks. Central banks can influence the money multiplier through the reserve requirements. The increase in reserve requirement helps the central bank to limit multiple deposits expansion in the banking systems. In the United States, commercial banks borrow reserves from Fed when the federal fund rate is higher than Feds discount rate.

Therefore, the reserve requirement is affected by the nature of both fed fund rate and feds discount rate. Also, the quantity demanded of reserve is determined by its price (interest rate) in the fed fund market. The quantity demanded increases with a decrease in interest rate and vice versa. In this regard, central banks can, therefore, affect the demand for reserves of commercial banks just by changing reserve requirement. Unlike other monetary tools, the impact of changes of reserve requirement is spread evenly across all banks to bring about neutrality.

Changes in the reserve requirement tend to induce all banks to adjust their balance sheets rapidly. However, the reserve requirement is nowadays limited due to current sweep accounts and other loopholes of reserve requirement. Today central banks rarely use reserve requirement as the monetary policy tool because most banks operate around it (Thomas 418).The open market operate under the monetary base; that is, MB = C + R. Open market operations are preferable by most central banks because they can help to expand or contract monetary base to a precise level.

With the use of open market operations, the central bank can reverse mistakes quickly because they are under its control. Open markets operations help to support the discount policy rate especially when there are excessive reserves. In the United States, Fed moves the equilibrium rate by use of open market operations toward the target established by the federal committee of open market operations. In addition, Fed can add reserves to the system by buying assets such as Treasury bond and can remove them from the system by selling these assets.

Therefore, the central bank sells assets to increase the money base as well as the money supply in the system and vice versa. The central bank conducts open market operations to get the interbank lending rate near its target. Unlike other monetary tools, OMO lack announcement effect because they are conducted on a daily basis. It takes time also for the impact of OMO to reach out remotely located areas since its initial impact is concentrated within the money market centers (Jain & Igor 271).

The application of monetary tools differs from one central bank to another depending to the economic nature of the country. For instance, national central banks of ECB and the Fed’s district banks have similar and different applications of monetary tools. Both these central banks use open market operations instead of reserve requirement or discount loans. They also use open market operations to get the interbank lending rate of the overnight market towards it target. They also lend to banks at a marginal lending rate that is fixed 100 basis points higher than the overnight cash rate.

Besides both these central banks use repos as well as reverse repos for defensive, reversible open market operations and outright purchases for long-lasting additions to the monetary base. Both also use the corridor system to pay interest on reserves. These central banks cap the market rate using the discount rate on the upper end and reserve rate at the lower end. Unlike the Fed’s district banks, national central bank of ECB spreads the love around in order to conduct open market operations in various cities within the European Union.

Works citedThomas, Lloyd B. Money, Banking, and Financial Markets. Mason (OH: South-Western, 2006. Print.Jain, Chaman L, and Igor M. Tomic. Essentials of Monetary and Fiscal Economics. Flushing, N.Y: Graceway Pub, 1995. Print