The most importan Federal Reserve's policy tool is the open market operation.What makes this tool so effectiv?

Answer 1

In any type of policy implementation, there are two types of lags: Inside Lag and Outside Lag (your class may use different terminology).

Inside Lag is the time it takes for a policy to be enacted.

Fiscal Policy can be tied up for months, even years, by Congress.
Monetary policy is not bound by this requirement.


Outside Lag is the time it takes for a policy to be realized in the economy.........again, the money supply starts having an effect immediately, where as tax cuts or government spending takes a while to kick in.


This should be straight out of your macro text.

Answer 2

Feds will control the money supply, and borrowing thru interest rates. They see a inflation or borrowing getting out of hand it raises the internest rates on loans. The federal Reserve is good because it independant from the goverment to make fiscal discisions for the economy. Without a independant central bank politcains would control the economic cycle that would lead to problems.

Answer 3

The open market tool is effective because it has an immediate effect on the money supply.

When the Fed buys $100M in T-Bills, that essentially exchanges $100M in bonds of private portfolios with $100M in cash. Those people and institutions don't want that cash to sit around. They want to turnaround and immediately re-invest it.

Similarly when they sell, they pull cash from portfolios reducing funds available for investment.

This ability to push or pull cash instantly means they can react quickly to changes in cash demands such as seasonal demands (xmas, harvest) or national emergencies.