Wednesday, July 22, 2009

Effects of open-market operations(1)

When the Fed purchases or sells securities on the open market, the economy is affected in three direct ways:
1. Depository institutions reserves changes.
2. The price (and, therefore, the yield) of securities.
3. Economy wide expectations change.
Changes in Reserves the Fed purchases of treasury bills from a depository institution change that depository institution's reserves. Briefly, if the Fed purchases $1 million worth of T-bills from a depository institution, the fed eventually pays by increasing the reserve account of that institution. That means that the depository institution changes its asset portfolio's structure. It now has $1 million less in T-bills and 1$ million more in reserve deposits at the fed. The Fed has a 1$ million increase in its assets (T-bills) and in its liabilities (deposit obligations to the selling depository institutions).
A depository institution's reserves also increase if the fed purchase the 1 $ million T-bill from the private sector. Thus, whenever the fed purchases U.S. government securities, depository institution reserves increase by exactly the amount of the purchase, furthermore, other things being constant, the quantity of money will expand by some multiple of the original Fed purchase. This increase in the money stock may, ultimately, lead to an increase in the level of economic activity.
Complementary reasoning indicates that the sale of a T-bill by the fed to depository institution or to the nonbank public decreases overall depository institution reserves and normally leads to a multiple contraction in the quantity of money. This contraction in the money stock eventually may.lead to a reduction in economic activity

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