Answer to Question #190799 in Economics for shargeel khan

Question

What interest rate is most directly affected by open market operations? 

Answer 1

Open market operations are the most commonly used monetary regulation tool in world practice. This is due to the fact that this tool has a set of serious advantages over the others.

1. The Central Bank fully controls the volume of transactions. Using this tool, the Central Bank directly determines the number of excess reserves in the banking system. This is impossible, for example, when using the instrument of lending to banks at the refinancing rate, when the Central Bank only reduces or increases the attractiveness of refinancing for banks, but does not control the volume of lending.

2. Open market transactions are accurate. They can be carried out in any volume. Even if very little change in reserves or base money is required, open market operations allow for such an accurate adjustment (there will be little purchases or sales of securities). At the same time, if the required change in reserves is large enough, the mechanism of open market operations is powerful enough to bring about such a major change.

3. Open market transactions are easily reversible. The Central Bank can immediately correct an error made during operations by conducting an opposite transaction.

4. Operations on the open market are very fast. It is possible to make a decision to carry out these operations almost immediately (after several hours or even minutes) after the receipt of the information on deviations in the target value of the monetary base.

3. Deposit policy.

To regulate the monetary base and money supply, the Central Bank can use operations to attract excess reserves of commercial banks to deposit accounts with the central bank. The deposit policy has been actively applied by the Bank of Russia since 1996. Given the underdevelopment of other Central Bank instruments, this policy has long remained the main (along with refinancing) instrument of monetary regulation. During the periods when there was a strongly positive balance of payments (1996, 2000-2003), the deposit policy became the main instrument of the Bank of Russia. With the help of this instrument, the Central Bank attracts funds from banks after holding deposit auctions among them.

The deposit policy can be divided into two types:

1) Change in the number of deposit auctions held by the central bank. If commercial banks increase excess reserves, the Central Bank holds an additional deposit auction, which attracts free funds of some banks. In this case, the Central Bank absorbs the excess liquidity of the banking system and does not allow banks' assets to be directed to the foreign exchange or credit market. If, on the contrary, commercial banks have insufficient reserves, the Central Bank reduces the number of deposit auctions or does not conduct them at all. In this case, it restores the liquidity of the banking system and facilitates the active operations of banks.

2) Change in interest rates on deposits. By increasing the interest rate on deposits, the Central Bank increases the attractiveness of placing funds on its accounts for banks and stimulates the reduction of excess reserves. By lowering the interest rate, the Central Bank, on the contrary, reduces the attractiveness of investments in deposits for banks and stimulates the growth of reserves and, accordingly, lending activity.