Open Market Operations
Course Outline
Open Market Operations
What are open market operations?
An open market operation is when the Federal Reserve buys and sells Treasury bills to change the amount of money in the economy. This practice is one of many tools the Fed can use to influence monetary policy.
The Fed determines how much to trade by targeting the federal funds rate. This rate, which is the overnight lending rate banks charge one other, theoretically influences other interest rates throughout the economy.
With us so far? Let’s sum up: open market operations change the money supply, which affects the supply of loans and changes interest rates, which affects the quantity of loans demanded.
Now there are two types of open market operations: expansionary and contractionary. We’ll go over each.
Expansionary Open Market Operations
When the Fed wants to increase the money supply and lower interest rates, they purchase Treasury bills from banks. This increases the supply of bank reserves.
What do the new reserves mean? Bank can make more loans! This stimulates the economy by making it easier to get a mortgage or start or grow a business. Increasing bank reserves also helps lower the federal funds rate because it decreases the opportunity cost of banks making loans to other banks.
Contractionary Open Market Operations
When the Fed wants to decrease the money supply and increase interest rates, they sell Treasury bills to banks. This decreases the supply of bank reserves.
Contractionary open market operations slow down an economy. That may seem counterintuitive, but they can help slow down inflation and correct for other distortions in the economy.
Open Market Operations After the Great Recession
While open market operations have historically been one of the important tools the Fed used to influence the economy, that changed after the 2008 financial crisis. We cover this in more detail in How the Fed Works: After the Great Recession.
Want to learn more about U.S. monetary policy and the Fed’s role? Check out our Macro section on Monetary Policy and the Federal Reserve.
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Transcript
What are open market operations? Open market operations are one of the many tools the Federal Reserve Board has at its disposal to influence monetary policy. An open market operation is when the Fed buys and sells Treasury bills to change the amount of money in the economy. The Fed makes these trades with other banks, and decides how much to trade by targeting a particular interest rate known as the "federal funds rate," which theoretically affects other interest rates in the economy. So open market operations changes the money supply, which affects the supply of loans, and changes interest rates, which affects the quantity of loans demanded.
There are two types of open market operations -- expansionary and contractionary. An expansionary open market operation is when the Fed wants to increase the money supply and lower interest rates by purchasing Treasury bills from banks, thus increasing the supply of bank reserves. The new reserves would allow banks to make more loans, thus stimulating the economy, making it easier to start or expand new businesses, or easier to get a mortgage. This increase in bank reserves would also lower the opportunity cost of banks loaning those reserves out to other banks, and that, in turn, would lower the federal funds interest rate. A contractionary open market operation is when the Fed wants to decrease the money supply and increase interest rates by selling Treasury bills to banks, thus decreasing the supply of bank reserves.
You may be thinking, "Why would you ever want to slow down an economy?" Well, contractionary policies are usually used to slow down inflation, or correct for other distortions in the economy. Historically, open market operations were one of the most important tools the Fed had at its disposal to influence the economy. However, in more recent times, after the Great Recession, the Federal Reserve has relied more heavily on its other tools.
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