Open Market Operations Vs Federal Reserve

In the United States, as well as most other countries today, the banking system in place is one known as a fractional-reserve banking system. This means that banks hold a portion of the deposits they receive, called reserves, and loan out the rest to borrowers with interest to make profits as well as to multiply the money in circulation. Ordinarily, a central bank is also present to implement monetary policy and control the money supply through various methods. The Federal Reserve, or the Fed, is the central bank in the United States, and in order to manage the money supply and influence the Federal funds market, it uses key tools such as Open Market Operations (OMOs), changing the discount rate, and changing the reserve requirement for

The main distinction, however, is that the discount rate is the interest that commercial banks pay in order to borrow money from the Federal Reserve, while the Federal funds target rate is the interest rate that the FOMC would like banks to be paying to borrow money from other commercial banks. Another difference which is important to note is that the discount rate is a regulated rate set by the Board of Governors of the Federal Reserve System, while the Federal funds rate is a market interest rate that changes based on the current market for loans. This means that only the discount rate is actually directly controlled by the Federal Reserve. The Federal funds rate is only influenced, or indirectly controlled, by the Federal Reserve through its changing of the discount rate or through the other few tools for implementing monetary policy. The discount rate and Federal funds rate and how they are changing are significant indicators of how well the economy is doing , as they strongly influence the interest rates at which regular people and businesses can take out loans from commercial banks for investments, cars,

However, when they do change it, the money supply changes as well because of the effect of the money multiplier equation. An increase in reserve requirements results in a lower money multiplier and therefore, a decrease in the money supply, whereas a decrease in reserve requirements leads to a higher money multiplier and an increase in the money supply. This is explained by basic mathematics, because the reciprocal of a large number is a smaller number, and vice versa. More recently, changing the required reserve ratio is not a very effective way of implementing monetary policy because many commercial banks generally keep excess reserves