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- Compare and contrast the "tools of monetary policy" in terms of their relative usefulness.
According to Ireland, there are three main tools of monetary policies that are followed by most financial institutions around the globe; these are open market operations abbreviated as OMO, the discount rate and the reserve ratios or changes in the requirements of the reserve (Ireland, 2010). These policies determine the way the government through the ministry of finance manages the economic functions of the nation and how monies are allocated to different parastatals. The Open Market Operations is the most active monetary instrument used by most central banks to manage its liquidity. These operations are conducted through the sale and purchase of government securities by the use of repurchase agreement (REPO) with commercial banks. There are two different types of open market operations; open market purchases and open market sales. In Open market purchases the government buys government securities to increase the monetary base while in open market sales the government sells its securities to decrease the monetary base.
When it comes to discount rate, Ireland has observed that when a bank receives a discount loan from the central bank, it is said to have received a loan at the "discount window." The central bank can affect the volume of discount loans by setting the discount rate: the higher the discount rate makes discount borrowing less attractive to banks and will therefore reduce the volume of discount loans. In contrast to that, a lower discount rate makes discount borrowing more attractive to banks and will therefore increase the volume of discount loans (Ireland, 2010). The advantage of the discount loan is that they allow the government to be the last borrowing option during financial meltdown. There are however some limitation to this, one of them is that during this time the government can take advantage of the situation and influence the volume of the discount loans. Another disadvantage is that for any changes to occur, they must first be proposed by the central government and be approved by the Board of Governors before the funds can be released. This is not easy to accomplish. As mentioned in this paper, the third option is the changes in reserve requirement, by affecting the money multiplier, changes in the required reserve ratio can lead to changes in the money supply.
- Why is changing the discount rate not a viable tool for conducting monetary policy?
As indicated in the previous chapter, the central bank can affect the volume of discount loans by setting the discount rate: the higher the discount rate makes discount borrowing less attractive to banks and will therefore reduce the volume of discount loans. In contrast to that, a lower discount rate makes discount borrowing more attractive to banks and will therefore increase the volume of discount loans (Ireland, 2010).
From the above explanation, the central bank has an upper hand when it comes to implementing this policy and therefore the "borrowers" will be charged abnormal interest rate if the borrow from the government coffers especially during economic crisis. It is therefore upon the stakeholders in the banking sector to implement policies that will not give one side an upper hand over the other. Another limitation of this policy is that the central bank cannot be sure how many banks will request discount loans at any given interest rate.
- Explain why the Federal Reserve is less "independent" than it appears to be.
Before we answer the above question, it is important for us to first look at the main functions of the Federal Reserve. According to Weintraub, these functions are clear checks, issue new currency, withdraw damaged currency from circulation, administer and make discount loans to banks in their districts, evaluate proposed mergers and applications for banks to expand their activities, act as liaisons between the business community and the Federal Reserve System, examine bank holding companies and state-chartered member banks, collect data on local business conditions and finally use their staffs of professional economists to research topics related to the conduct of monetary policy (Weintraub, 1978)
From the above functions, it is obvious that the federal reserves are not independent because they work in collaboration with other stake holders in the sector and any decision that is made is not a Federal Reserve decision but it must be a decision made after much consultation. In addition to that the presidents of the Federal Reserves are answerable to the six members of the Board of Governors who in turn report to the chairman of the Board of Governors. This therefore means that the Federal Reserve is not as independent as it appears to be.