In order to overcome this problem, it is recommended that the policy implementation shall be incremental in nature with built in mechanisms to set threshold levels to trigger automatic responses where policy do not seem to deliver the desired monetary policy outcomes.
Open market operations is one of the most frequently used tools that is being exercised by any central bank including FED. Open market operations basically involve the buying and selling of securities in open market in order to achieve the different monetary policy outcomes. Open Market Operations tend to provide an opportunity to FED to affect the banking system in following manner:
1. Affecting interest rates: through open market operations, FED basically mop out or in the liquidity within the banking system. By buying the securities, FED basically increase the supply of loanable funds thus interest rates tend to go down for short term period whereas by selling the securities, the liquidity is decreased which than increase the interest rates.
2. Controlling the volume of Credit: Through open market operations, FED basically increase or decrease the volume of credit as it either suck in the excess liquidity from the market or pump in new funds into the system. Through both methods, the overall extent of loanable funds can be increased or decreased in order to achieve the monetary policy objectives of the firm.
3. Open market operations also tend to affect the bank deposits because by floating securities in the market, FED basically take out funds from the banks which indirectly affect the deposits of the banks.
Banks are required to keep a certain percentage of their funds as reserve with the FED in order to meet the uncertainties. FED can increase or decrease this percentage with the passage of time and according to the economic situation. Further banks can also borrow from the one window facility at the FED and the rate charged by FED on such funds is called discount rate.