194 Monetary Policy and Open Market Operations
Learning Outcomes
- Explain and demonstrate how the central bank executes monetary policy through open market operations
Open Market Operations
The most commonly used tool of monetary policy in the U.S. is open market operations. Open market operations take place when the central bank sells or buys U.S. Treasury securities in order to influence the quantity of bank reserves and the level of interest rates. When the Fed conducts open market operations, it targets the federal funds rate, since that interest rate reflects credit conditions in financial markets very well.
Decisions regarding open market operations are made by the Federal Open Market Committee (FOMC). The FOMC is made up of the seven members of the Federal Reserve’s Board of Governors, plus five voting members who are drawn, on a rotating basis, from the regional Federal Reserve Banks. The New York district president is a permanent voting member of the FOMC and the other four spots are filled on a rotating, annual basis from the other 11 Federal Reserve districts. The FOMC typically meets every six weeks, but it can meet more frequently if necessary. The FOMC tries to act by consensus; however, the chairman of the Federal Reserve has traditionally played a very powerful role in defining and shaping that consensus. For the Federal Reserve, and for most central banks, open market operations have, over the last few decades, been the most commonly used tool of monetary policy.
LINK IT UP
Visit this website for the Federal Reserve to learn more about current monetary policy.
To understand how open market operations affect the money supply, consider the balance sheet of Happy Bank, displayed in Figure 1. Figure 1(a) shows that Happy Bank starts with $460 million in assets, divided among reserves, bonds and loans, and $400 million in liabilities in the form of deposits, with a net worth of $60 million. When the central bank purchases $20 million in bonds from Happy Bank, the bond holdings of Happy Bank fall by $20 million and the bank’s reserves rise by $20 million, as shown in Figure 1(b). However, Happy Bank only wants to hold $40 million in reserves (the quantity of reserves that it started with in Figure 1(a), so the bank decides to loan out the extra $20 million in reserves and its loans rise by $20 million, as shown in Figure 1(c). The open market operation by the central bank causes Happy Bank to make loans instead of holding its assets in the form of government bonds, which expands the money supply. As the new loans are deposited in banks throughout the economy, these banks will, in turn, loan out some of the deposits they receive, triggering the money multiplier and increasing the supply of money.
Try It
Where did the Federal Reserve get the $20 million that it used to purchase the bonds? A central bank has the power to create money. In practical terms, the Federal Reserve would write a check to Happy Bank, so that Happy Bank can have t