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Open market operations, which consist of purchases and sales of government securities, is the Federal Reserve’s conventional device for exercising monetary policy. Based on the Fed, the term monetary policy refers to the actions taken by a central bank to influence the availability and cost of money and credit and to help promote national economic goals (FederalReserve.gov). These securities transactions help dictate the federal funds rate (rate at which banks lend excess reserves to one another). The fed funds rate is significant to our economy because it somewhat controls the overall financial situation, affecting employment, output, and the overall level of prices.
In 1913, the Federal Reserve Act was passed, giving the Fed authority for setting monetary policy. In 1935, the Federal Open Market Committee (FOMC) was created. They are the board in charge of setting monetary policy for the Fed. THE FOMC implements the policies and also discloses them to the public. The board consists of 12 members that serve one-year terms on a “rotating basis”. They hold 8 scheduled meetings a year, and discuss economic and financial conditions, proper stances of monetary policy, and risk-assessments of things like price stability and sustainable economic growth (FederalReserve.gov).
GOALS of MONETARY POLICY
The two primary goals of monetary policy are to promote sustainable output and employment to the highest capacity and to promote price stability. Although monetary policy cannot affect these two things in the long run, it certainly can help influence them in the short-term. An example of this is interest rates. The Fed can lower interest rates to help raise demand and thus help to momentarily stimulate the economy. The problem with this, though, can be inflation. In the long run, attempting to fuel an economy beyond its capabilities will not help unemployment rates or output, but rather, just create more inflation, hurting economic growth.
OPEN MARKET OPERATIONS: TOOL of MONETARY POLICY
Open market operations are very useful in exercising monetary policy due to their relation with the total supply of balances at the Federal Reserve and the federal funds rate (Edwards, pg. 859). At the federal funds market, using the fed funds rate, depository institutions lend Federal Reserves balances to one another. The total amount of Federal Reserve balances that are available to these institutions is assessed via open market operations. These operations are aimed at either achieving a desired quantity of balances, or a desired price. The problem is that it is difficult to attain both, considering they negatively converse one another. According to Cheryl L. Edwards, of the Boards Division of Monetary Affairs:
“The greater the emphasis on a quantity objective, the more short-run changes in the demand for balances will influence the federal funds rate; conversely, the greater the emphasis on a funds-rate objective, the more shifts in demand will influence the quantity of Federal Reserve balances.”
Throughout the years, the Fed has used both methods for open market operations.
There are numerous reasons as to why the Fed uses open market operations to control monetary policy. First, the Fed has complete control over the type of open market operation and its size. Second, open market operations can be implemented quite hastily and without delays. They are also flexible, so the Fed can quickly reverse any mistakes. Lastly, the funds rate lets the FED adjust reserve balances when things past the Fed’s control cause reserves to rise and fall (Akhtar,1997).
With everything, there are advantages and disadvantages. The disadvantages of open market operations relate to specific, isolated situations. For example, if the money market is not developed, the central bank can’t exert full control over the bank reserves(blurit.com). Also, if commercial banks have excess reserves but still use an easy lending policy, the sale of government securities will not have the intended effect of lowering cash reserves of the commercial banks. And if there is a return of notes from circulation, the securities sale might not be able to “reduce the cash reserves of member banks”.
HOW FED USES OPEN MARKET OPERATIONS
The Federal Reserve operates open market operations with primary dealers (government securities dealers that have a strong trading relationship with the Fed (newyorkfed.org). These dealers hold accounts at depository institutions, so when the Fed does funds transactions with the dealer at it’s bank, the transaction either adds to or takes away from the reserves in the banking system. Because of this, open market operations indirectly influence the fed funds rate. Changes to the fed funds rate ultimately have a powerful effect on other short-term rates.
In conclusion, open market operations have always been the most prominent of the three tools used in affecting monetary policy. In today’s technological and highly competitive financial environment, monetary policy can sometimes be difficult, but the Fed still accepts open market operations as the most essential way to control our policies. As Michael Akbar Akhtar, vice president of the Federal Reserve Bank of New York, explains:
“Among the policy instruments used by the Federal Reserve, none is more important for adjusting bank reserves than open market operations, which add or drain reserves through purchases or sales of securities in the open market. Indeed, open market operations are, by far, the most powerful and flexible tool of monetary policy”
– http://research.stlouisfed.org/aggreg/meeks.pdf. Understanding Open Market Operations, M.A. Akhtar. Federal Reserve Bank of NY, 1997.
-http://www.federalreserve.gov/pubs/bulletin/1997/199711lead.PDF. Open Market Operations in the 1990’s, Cheryl L. Edwards.