Jul
22
The Open Market Purchase also affects an interest rate. In particular, it immediately affect the Fed Fund Rate
July 22nd, 2010 posted by
admin
In this case ( a purchase), it tend to raise or lower rates ??? This interest rate, like all interest rates, has associated with it a borrower and a lender. In this case, who borrows what from whom?
If $100,000,000 is loaned for the typical period that these loans are made for, how much interest (in dollars) goes from the borrower to the lender ?
senekon says:
July 24th, 2010 at 3:04 am
When an open market purchase is conducted by the Fed, the price of the bonds purchased would tend to rise because the higher demand for of securities. If the Fed buys the bonds / treasury security freshly issued from the Govt. ( the borrower of money), the Govt. will offer a slightly lower interest rate than the going ineterst rate on govt. security of the corresponding tenure rate in the market. Here the Fed is the lender intending give more loans to the Govt.. If the Fed buys the existing securities from the discount houses or banks, demand for these securities go up in the market, their prices rise and therefore interest rate should tend to fall. In this case, there is no fresh borrowing from any one: it is a situation of buying and selling of existing financial assets. However, when the same market operations is reallydone through the mechanism of Repos and Reverse Repos (see details in the Note below), the borrowers and lenders are the FED and the Banks. For open market purchase operations, the the Fed enters into Repo ( Repurchase agreements with different banks by which the Fed buys the govt. securities from banks and credit electronically the purchase consideration amount to their Reserve account with the Fed – thereby helping them to increase lending based on the additions to their reserves: this is called a Repo agreement because under the agreement the banks are required to repurchase these securities after a pre-specified period of time. iN THIS CASE, THE BANKS ARE THE BORROWERS AND THE fED IS A LENDER. (in the reverse repo the situation is just the opposite).
The rate of interest of these borrowing and lending vary fromntime to time. But these are the rates on interest on the shorter maturities of treasury securities/ bonds.
Notes:
1.In the U.S., the Federal Reserve (Fed) most commonly uses overnight repurchase agreements (repos) to temporarily create money, or reverse repos to temporarily destroy money. Alternatively, it may permanently create money by the outright purchase of securities. Very rarely will it permanently destroy money by the outright sale of securities. These trades are made with a group of about 22 banks or bond dealers who are called primary dealers.
Money is created with a repo simply by electronically increasing the reserve account at a bank, that is by issuing a new liability of the central bank. Money is destroyed with a reverse repo simply by decreasing the reserve account of a bank, that is by destroying a liability of the central bank. The Fed has conducted open market operations in this manner since the 1920′s, through the Open Market Desk at the Federal Reserve Bank of New York, under the direction of the Federal Open Market Committee.
Increasing the required reserve ratio reduces the lending ability of banks thus contracting money supply. Another way is the outright sale of government securities, which are paid with bank reserves, thus contracting Money Supply. The Fed buying securities pumps in cash into the system via the required reserve ratio, thus expanding Money Supply.