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Making Sense of the Federal Reserve

A Closer Look at Open Market Operations

Expansionary Monetary Policy
STEP 1: When the Fed buys government securities through securities dealers in the bond market, it deposits the payment into the bank accounts of the banks, businesses, and individuals who sold the securities. 
STEP 2: Those deposits become part of the funds commercial banks hold at the Federal Reserve and thus part of the funds commercial banks have available to lend.
STEP 3: Because banks want to lend money, to attract borrowers they decrease interest rates, including the rate banks charge each other for overnight loans (the federal funds rate).
Contractionary Monetary Policy
STEP 1: When the Fed sells government securities, buyers pay from their bank accounts, which decreases the amount of funds held in their bank accounts.
STEP 2: Banks then have less money available to lend.
STEP 3: When banks have less money to lend, the price of lending that money—the interest rate—goes up, and that includes the federal funds rate.

The term "open market" means that the Fed doesn't decide on its own the securities dealers with which it will do business. Instead, various securities dealers compete on the basis of price in the government securities market.

The FOMC sets a target for the federal funds interest rate and attempts to hit the target by buying or selling government securities.

How do open market operations actually work? Currently, the FOMC establishes a target for the federal funds rate (the rate banks charge each other for overnight loans). Banks take overnight loans to ensure that they have the necessary funds to meet the reserve requirements of the Federal Reserve System—a topic that is addressed later. The federal funds rate is important because movements in the rate influence other interest rates in the economy. For example, if the federal funds rate rises, the prime rate, home loan rates, and car loan rates will likely rise as well.

The Federal Reserve uses open market operations to arrive at the target rate. Open market operations consists of the buying or selling of government securities. The Fed holds government securities, and so do individuals, banks, and other financial institutions such as brokerage companies and pension funds.

As mentioned before, open market operations involve buying and selling government securities. We refer to the Fed's purchase of government securities as expansionary monetary policy and its sale of government securities as contractionary monetary policy. In the next section, you will learn more about what expansionary and contractionary policy mean.

Expansionary Policy
Open market purchases of government securities increase the amount of reserve funds that banks have available to lend, which puts downward pressure on the federal funds rate. Policymakers call this easing, or expansionary monetary policy. If the economy were a car and the FOMC its driver, expansionary policy would be like gently pushing on the accelerator—giving the economy a little more fuel.

Contractionary Policy
Sales of government securities shrink the funds available to lend and tend to raise the federal funds rate. Policymakers call this tightening, or contractionary monetary policy. Again, if the economy were a car and the FOMC its driver, contractionary policy would be like lightly tapping on the brakes—not enough to stop the car, but rather to slow its momentum a bit.

The FOMC uses open market operations like an accelerator and brake pedal to influence economic performance. By targeting the federal funds rate, the FOMC seeks to provide the monetary stimulus needed for a healthy economy. After each FOMC meeting, the federal funds rate target is announced to the public.

Next: Conducting Monetary Policy »