Tuesday, May 5, 2020

Strength and Weakness of Open Market Operation

Question: Discuss about the Strength and Weakness of Open Market Operation. Answer: Introduction: One of the most widely used and active monetary policy used by central banks in a country with well-developed capital market is open market operation. Monetary aggregates would be controlled in a more flexible way using this policy instruments. Open market operations is the initiative taken by monetary authority for selling and purchasing of financial assets in capital market along with Effectiveness of other monetary policy instruments such as reserve requirement and discount policy can be reinforced using the open market operation (Adrian and Liang 2016). There is a direct and immediate impact on bank reserves that affects the credit creating capacity of banks. Discussion: Nature of money Creation and its Impact on Economy: Capital market interest rate and cash rate in the economy is affected through the whole structure of lending and deposit rates. Lending and deposit rates does not always keep in pace with cash rate because of fluctuation in level of competition in the banking sector. Money is created by banks in the form of deposits and by making new loans. Money is created by banks whenever they buy an asset from customers and lend money in economy. The balance sheet of the commercial sector increases when the money is created in the form of lending (Battiston et al. 2016). However, several factors cause difference between the amounts of money created and distributed in the economy. Aim of open market operation of central banks influences the cash reserves and quantity of money in the economy. In accordance with the increase and decrease in the cash reserves of central banks, the banks seek to increase, decrease the loan and investment. When the Federal Reserve buys the government bonds, new money is used to pay for them and this put control over the size of money supply. Money supply immediately goes up once the government securities are immediately bought through the open market operations. This is so because interest rate is influenced by change in the money supply and ultimately investment and saving decisions in the economy (Gandolfo 2013). Cash rate in the money market is determined by the interaction between the supply and demand in the economy. If more exchange settlement funds are supplied by central banks compared to amount hold by commercial banks in the economy, banks would lend more money in the cash market and this would cause the cash rate to fall. Process other way round would bid up the cash rate. Cash rate are feed through the whole structure of lending and deposit rates. In order for banks to satisfy reserve requirement and manage liquidity, banks lends and borrow money in the interbank lending rate. Constraint of reserve requirement is binding all the times as banks rarely hold significant excess reserves. Banking industry experiences a decline in the reserve requirement when the monitory policy is tighten using the open market operation (Brunnermeier and Sannikov 2016). Alternative monetary Policy Due to Ineffective of Open market Operation: Open market operation becomes inert in severe crises and it affects the interest rate in normal times. Central banks have made injection of reserves into the banking system by adopting the unconventional monetary policy of quantitative easing. When the bank makes loans, it enables the creation of money. Banks in the aftermath of financial crisis stopped making money by way of lending. Some of the alternative monetary policy adopted by some of the countries was Quantitative easing. Quantitative easing is a monetary policy that is instituted by central banks for stimulating the local economy. Using this policy, government increase the supply of money in the economy and maintained lower rate of interest artificially and at the same time providing customers with extra money to spend. Quantitative Easing Employed by Several Countries: Quantitative easing was employed by federal reserve with the hope of steering the largest economy through financial crisis. In US, quantitative easing was coupled with lower interest rate that help in freeing up capital and this led to rise in price of shares in the US economy. After the initiation of quantitative easing initiated in the US. Given the slowdown in inflation in US, the central bank is cautious in raising the borrowing costs (Grubel 2014). In the wake of financial growth and in the wake of financial crisis, Bank of England has embarked on quantitative easing. In light of quantitative easing programme, UK government created new money worth $ 550 billion (Taylor 2013). Introduction of this monetary policy helped in creating overall financial stability and credit conditions. Japan was plagued in recent history by rolling recession and deflation and the quantitative easing was described as effort of the country in raising the price and kick starting the growth. However, quantitative easing was not successful in making the country rid of persistent deflation. Under the plan of quantitative easing, japan banks vowed to buy government bonds worth 46 billion each money using electronically created money. Quantitative easing policy is seized on by the critics of policy and how the economic record would help in warding off deflation and recession (Kindleberger 2015). The current monetary policy of japan aimed at removing the deflationary bias and the inflation trend needs to be targeted for increasing the investment and consumption in the market of Japan. The earlier monetary policy was not successful in increasing the liquidity as it did not led to increase in domestic demand. Policy of Quantitative easing urged people to make increased investment and consumption as excess money supply in the economy would lead to inflation in the near future (Starr 2014). This policy enabling easy purchase of government bonds can be a subject of political pressure. Conclusion: From the above discussion, it can be concluded that the success of open market operation is dependent on number of factors. Open market operation is ineffective if the government securities market is not well diversified and large. Open market operation has limited impact if there is inadequate supply of government securities. Application of fractional reserve and open market operation fail to achieve the monetary objectives in most of the cases. Success of open market operation and fractional reserves in the economy depends upon the prevailing economic conditions of country and circumstances. It is essential to develop actively securities market and liberalizing the interest rate for achieving the open market operation objectives. Reference: Adrian, T. and Liang, N., 2016. Monetary policy, financial conditions, and financial stability. Battiston, S., Farmer, J.D., Flache, A., Garlaschelli, D., Haldane, A.G., Heesterbeek, H., Hommes, C., Jaeger, C., May, R. and Scheffer, M., 2016. Complexity theory and financial regulation.Science,351(6275), pp.818-819. Brunnermeier, M.K. and Sannikov, Y., 2016.The I theory of money(No. w22533). National Bureau of Economic Research. Gandolfo, G., 2013.International Economics II: International Monetary Theory and Open-Economy Macroeconomics. Springer Science Business Media. Grubel, H.G., 2014. A theory of multinational banking.PSL Quarterly Review,30(123). Kindleberger, C.P., 2015.A financial history of Western Europe. Routledge. Starr, R.M. ed., 2014.General equilibrium models of monetary economies: Studies in the static foundations of monetary theory. Academic Press. Taylor, J.B., 2013.Getting off track: How government actions and interventions caused, prolonged, and worsened the financial crisis. Hoover Press.

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