Wednesday, July 22, 2009

Effects of open-market operations(2)

Interest rate changes as the price of a bill or bond changes, so, too, does its yield. An increase in the purchase of bonds will cause bond prices to rise, which amounts to a decrease in bond yields. A decrease in pond purchases causes bond prices to fall and bond yields to rise.
Because the Fed is a large buyer\seller relative to all other buyer\seller of U.S. government securities, the fed can (usually) affect the price of a bill or bond directly. It follows that the fed can also influence interest rates. In principal, the Fed could, if inflation expectations were constant. Change short-, medium-, or long-term interest rates by buying or selling securities aggressively in any of these markets. To maintain a give price (and therefore interest rate) for a bill, all the fed need do is to be prepared to buy or to sell as much as the rest of the traders care to sell or to buy at that "going" security price (interest rate)
Changes in expectations an "announcement effect" exists for open-market operations, as well as for the other monetary tools. " Fed watchers"- stock market analysts, brokerage house employees, general investors, corporate treasurers, and a host of other individuals, including university professors-monitor open-market operations and make their predictions about the future effects of open-market operations on such economic variables as interest rates and inflation. Unfortunately, complete agreement does not exist among economists a bout how expectations change specifically when specific open-market operation changes occur. On the one hand, one might interpret an increase in Fed purchases of securities as an expansionary monetary policy that will cause lower interest rates, increased business production and investment, and increased consumer spending. On the other hand, expansionary monetary policy might induce expectations of still higher future increase in the money stock and the anticipation of inflation. The expectation of higher rates of inflation will encourage money lenders to place an inflationary premium on interest rates; nominal interest rates will then rise. Moreover, an expectation of increased inflation may well discourage business investment and consumer spending.
Nonetheless, the view that open-market purchases are expansionary, even accounting for adjustments, remains the dominant view within the economic profession.

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