DSST Money & Banking Part 1

Defensive open market operations operations aimed at

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Defensive Open Market  Operations:  Operations aimed at  offsetting undesired changes in the base due to  factors  such as the collection of taxes by the Treasury.
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Dynamic Open Market  Operations:  are purchases and sales designed to increase or decrease the base so as  to hit policy targets, such as the money supply specified by the FOMC.   Purchases by the FOMC INCREASE the  monetary base and the money supply and lower interest rates as the money supply increases.   Discounting and Advancing:  Beyond Reserve Requirements, the 2 nd  major tool of the FED is discounts and  advances.  Discounting refers to cases where the FED purchases a loan made by the commercial bank at a  discount from the value of the loan.  If the discount rate were 10%, the FED would pay the bank 90% of the value  of the loan.  Even though most lending at the FED is in the form of advances, usually borrowing from the FED is  called discounting.  The rate charged by the FED in advances is also called the discount rate.   The FED supplies institutions with borrowed funds under three programs: Extended Credit for Exceptional Circumstances : applies in emergency cases when bank has used all  alternative sources and cannot meet liquidity needs – deals with failing banks and regional problems such  as natural disasters. Extended Credit for Seasonal Needs : applies for small banks that face substantial seasonal needs  Adjustment Credit : loans advanced for short periods of time to help banks meet needs that are not  satisfied by market sources.  Maximum of 14 day loans and are intended to meet unexpected, temporary  liquidity needs. The FED views discounting as a privilege and not a right :  The following are INAPPROPRIATE  reasons for borrowing: to substitute for normal sources of funds, to substitute for capital, to support loan  or investment expansion, to take advantage of the differential between market and discount rates.  There  is a  PROFIT MOTIVE or incentive to borrower from the FED; however, the FED IS A LENDER OF  LAST RESORT to stabilize the financial system. Announcement Effect:  Typically on the day after a discount rate is changed, market rates move at least  temporarily in the same direction as the discount rate because investors take the announcement as a  signal of FED monetary policy, such that if the FED announces an increase in the discount rate, the  market may view this as a signal that the FED intends to tighten monetary policy and raise rates.
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