July 5, 2007->1
July 6, 2007->2
T-Notes 10y, 30y
Contractionary Monetary Policy
As you can probably imagine, the effects of a contractionary monetary policy are precisely the opposite of an expansionary monetary policy. In the United States, when the Federal Open Market Committee wishes to decrease the money supply, it can do a combination of three things:
1.Sell securities on the open market, known as Open Market Operations
(See Vertical lines 1,2 at post 111: https://www.mql5.com/en/forum/177107/page8)
2.Raise the Federal Discount Rate
3.Raise Reserve Requirements
These cause interest rates to rise, either directly or through the increase in the supply of bonds on the open market through sales by the Fed or by banks.
This increase in supply of bonds reduces the price for bonds. These bonds will be bought up by foreign investors, so the demand for domestic currency will rise and the demand for foreign currency will fall. Thus the domestic currency will appreciate in value relative to the foreign currency. The higher exchange rate makes domestically produced goods more expensive in foreign markets and foreign good cheaper in the domestic market. Since this causes more foreign goods to be sold domestically and less domestic goods sold abroad, the balance of trade decreases. As well, higher interest rates cause the cost of financing capital projects to be higher, so capital investment will be reduced.
Expansionary Monetary Policy vs. Contractionary Monetary Policy
Open market operations are the Federal Reserve’s
principal tool for implementing monetary policy.
These purchases and sales of U.S. Treasury and federal
agency securities largely determine the federal
funds rate—the interest rate at which depository institutions
lend balances at the Federal Reserve to other
depository institutions overnight. The federal funds
rate, in turn, affects monetary and financial conditions,
which ultimately influence employment, output,
and the overall level of prices.
The Federal Reserve System and Monetary Policy
Banks earn profits by accepting deposits and lending part of those deposits to someone else. They sometimes charge fees for establishing and maintaining accounts and always charge borrowers an interest rate. However, banks do not lend all of their deposits. Banks are required by the Federal Reserve System to hold a portion of their deposits as reserves in the form of currency in their vaults or deposits with Federal Reserve System.
The Federal Reserve buys and sells bonds and by doing so, increases or decreases banks' reserves and banks' abilities to make loans. As banks increase or decrease loans, the nation's money supply increases or decreases. That, in turn, decreases or increases interest rates. The purchase and sale of bonds by the Federal Reserve is called open market operations. The Federal Reserve is "operating", that is buying or selling, in the "open market" for U.S. Treasury bonds.
When the Federal Reserve sells a bond, an individual or institution buys the bond with a check on their account and gives the check to the Federal Reserve. The Federal Reserve removes an equal amount from the customer's bank's reserves. The bank, in turn, removes the same amount from the account of the customer who purchased the bond. Thus, the money supply shrinks. The opposite occurs when the Federal Reserve buys a bond. The Federal Reserve gives a check to the seller of the bond. The seller deposits the check in their account. Their bank adds the amount to deposits and thus the money supply increases. The bank also presents the check back to the Federal Reserve, which in turn adds the amount to the bank's reserves. Because the bank has to keep only a portion of those reserves, the bank makes loans with the remainder. Thus the money supply expands even further. As banks attempt to make more loans, interest rates fall.
Open market operations are the primary tool of the Federal Reserve. It is a tool that is often used and is quite powerful. This is what the Federal Reserve actually does when it announces a new target for the federal funds rate. The federal funds rate is the interest rate banks charge one another in return for a loan of reserves. If the supply of reserves is reduced because the Federal Reserve has sold bonds, that interest rate is likely to increase. If the supply of reserves is increased because the Federal Reserve has purchased bonds, that interest rate is likely to decrease.
EconEdLink | EconomicsMinute | A Case Study: The Federal Reserve System and Monetary Policy - June 28, 2007
1.Federal Reserve sells bonds.
2.decreases banks' reserves
3.banks decrease loans
4.the nation's money supply decreases
5.That, in turn, increases interest rates.
T-Notes 10,30 Year yield
July 9, 2007