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A Closer Look at Open Market Operations

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 Federal Open Market Committee (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 Federal Open Market Committee (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 is 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

Step 1: When the Fed buys government securities through securities dealers in the bond market, it adds the payment to the accounts of the banks, businesses and individuals who sold the securities.
Step 2: Those payments become part of deposits in commercial bank accounts that commercial banks hold at the Federal Reserve — part of the funds that commercial banks have available to lend.
Step 3: Banks want to lend money and so to attract borrowers, they decrease interest rates, including the rate banks charge each other for overnight loans (the federal funds rate).

So, 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. This is called easing or expansionary monetary policy by policy-makers. 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 to work with.

Contractionary Policy

Step 1: When the Fed sells government securities, buyers pay from their bank accounts, which decreases the amount of funds held by the banks.
Step 2: Banks then have less money available to lend.
Step 3: When banks have less money to lend, the price of that money – the interest rate – goes up, and that includes the federal funds rate.

So, sales of government securities shrink the funds available to lend and tend to raise the funds rate. This process is called tightening or contractionary monetary policy by policymakers. 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.

In the example below, you will explore how monetary policy works in a fictional classroom economy.