Federal Reserve Wanted to Reduce the Amount of Liquidity in the Banking System

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Mary KraszewskiMay 14, 2013
National University
Finance 440- Financial Institutions

If the Federal Reserve wanted to reduce the amount of liquidity in the Banking system, how would they accomplish this via open market operations? The Federal Reserve uses three methods to influence the money supply in the United States. Their tools are: open market operations, discount lending and the reserve requirement but open market operations are the most essential to the control of the monetary policy. An open market purchase increases not only the monetary base but also the money supply. This in turn lowers short-term interest rates. To accomplish this expansion of the open market the Federal Reserve typically purchases Treasury securities for two reasons. These investments are not only capable of assuming large transactions but when the Federal Reserve purchases these securities from the public it circumvents making the loan to the public directly by making the loan to the Treasury. An open market purchase of Treasury securities by the Federal Reserve has no effect on resources of non-financial institutions but will increase the assets of the Federal Reserve and increase the credit available to the public. Conversely, the Federal Reserve has numerous standard guiding principles it uses to implement a contractional effect within the monetary system. These tools are conventionally instituted when the Federal Reserve suspects inflation is becoming uncontrollable. To create a reduction in liquidity, the Federal Reserve will sell assets into the marketplace. The monies received are then destroyed. The term given to this course of action is “mopping up” the liquidity. The Federal Reserve is, in essence, slowing economic growth by limiting the amount of credit available, loans become more expensive and in turn commodity prices eventually decline. The Federal Reserve can also raise the Reserve requirement. The Reserve requirement is the amount of funds that...
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