economy

Firstly, the main monetary tool to use when an economy is overheating is interest rates – the monetary authorities will increase rates to reduce the demand for money- i.e. it becomes more expensive to borrow. It follows that interest rates willbe low (as we have now) when we are faced with recession/depression. The Greenspan years (early 2000’s) are being widely blamed for the overheating in the US economy- the view is that interest rates should have been increased in the US to prevent the bubble in credit during those years- that has caused the crisis now – that said it is more complicated than that. Barmy lending practices, financial "innovation" and financial products not adequately supervised were another cause.

The Fed and the Eurozone use slighly differenet methods of Open Market Ops (OMO) but the end result is largely the same. The aim is to reduce/increase the amount of money supply in the relevant economy and this is adjusted daily. This is done by the issue of T Bonds/Gilts etc. and Repos.In the UK for example, the Bank of England has printed money (around £200bn) this year to date. That goes on one side of the Bof E’s balance sheet. Then it lends out this money to commercial banks so that they can, in turn, lend out the money to consumers/industry. That goes on the other side of its balance sheet.

This has been done in the UK because of the disasterous losses in the banking sector. Because of Capital Requirements (i.e. minimum reserve requirements), the banks have been unable to lend because most of them are technically bust-i.e. losses have wiped out capital. So the central monetary authority has to step in and lend to the banks so that they can lend again -to stimulate the economy.

There are 2 aspects of the reserve requirement. The first is the minimum amount that should be held by a Bank- that depends on the risk profile of loans on its balance sheet.Therefore,the higher the estimated risk, the higher the probability of default-meaning larger reserves against loss. The other side is the multiplier of that- banks can lend out a multiple of their reserves. (Fractional Reserve Banking). It follows logically that if a country is in recession -that the monetary authorities might ease up on the minimum required reserve and allow a greater multiple of that to be lent. Currently, however, the reverse is true. The reason for this is that following the financial crisis, it has emerged that risk assessment of bank assets (loans) has been woefully inadequate and the rules are being tightened to make it harder. So there is much tighter control of bank lending by the monetary authorities. (about time).

The discount rate is just the cost of borrowing money from the main monetary authority on its debt issuance and is adjusted daily depending on the balance of the amount of money outstanding i.e. if the authority wants more institutions to borrow then it will lower the rate to make it cheaper. In the UK there has been a punitive element however: the tax payer has had to bail out the Banks and an adequate return for the tax payer has to be built into the cost of borrowing from the governemnt.

Some links which go into greater detail:

OMO http://en.wikipedia.org/wiki/Open_market_operations

UK http://www.bankofengland.co.uk/markets/money/Index.htm

US http://www.newyorkfed.org/aboutthefed/fedpoint/fed32.html

Fractional Reserve Banking

http://en.wikipedia.org/wiki/Fractional-reserve_banking

Good luck – I really enjoyed this question! LOL – Sunday mornings eh?