When the Federal Reserve sells government securities on the open market What effect does this action have on the nations money supply and interest rates?

Monetary policy consists of the steps the central bank of a nation can take in order to regulate the nation's money supply. For instance, a central bank might reduce interest rates during a recession in order to make loans more readily available to other banks and thus stimulate economic recovery.

In the United States, the central bank is actually a system of twelve banks known as the Federal Reserve System, or more simply, the Fed. As with any central bank, the main job of the Federal Reserve is to conduct monetary policy for the U.S. government - to regulate the economy by regulating the supply of money in circulation. There are three basic ways in which the Fed accomplishes this.

Open Market Operations

The primary method by which the Fed conducts monetary policy is through the buying and selling of government securities on the open market. This process, called open market operations, is conducted regularly by the Fed as a way to manipulate the money supply.

Eight times a year, the Federal Open Market Committee (FOMC) meets to review and discuss reports on previous and prospecive economic developments. After the reports, each committee member presents his or her views on the state of the economy and a recommendation on monetary policy for the period of time until the next FOMC meeting. Upon reaching a consensus on monetary policy, the FOMC directs the Federal Reserve Bank of New York on the execution of sales or purchases of government securities.

When the Fed buys securities on the open market, cash is transferred to these banks, increasing the nation’s money supply. Conversely, when the Fed sells government securities, these banks have less cash available to them – a decrease in the nation’s money supply. In this way, the Fed can achieve specific monetary policy goals with short-term, sometimes daily, transactions.

Reserve Ratio

Because commercial banks keep reserve accounts with the Fed, either as actual deposits at a Federal Reserve bank or as “vault cash” at their own location, these transactions are made instantaneously and electonically. The amount of money kept in reserve by commercial banks is known as the reserve ratio and is another tool used by the Fed to implement monetary policy. The Fed may raise the amount of money banks are required to keep in reserve in order to decrease the money supply, or they may lower the requirement in order to make the banks more liquid and stimulate the economy. This mechanism is more drastic in its effect upon the commercial banks, and for this reason is used infrequently by the Fed.

Interest Rates

Instead, the Fed may use interest rates, such as the discount rate and the federal funds rate, to encourage or discourage lending among banks. The discount rate is the interest rate the Fed charges on loans it makes to commercial banks. By reducing the discount rate, the Fed makes it more attractive for commercial banks to borrow money. As they do so, the nation's money supply increases and the economy expands. Similarly, commercial banks that keep monetary reserves with the Fed can loan this money, these federal funds, to each other. These loans are made at the Federal Funds Rate, another rate that the Fed has the power to raise or lower in order to impact the money supply.

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Economics 14

Lecture 19: Monetary Policy

Federal Reserve
tools of monetary policy
expansionary monetary policy
contractionary monetary policy

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Federal Reserve

Monetary policy involves control of the quantity of money in the economy. The Federal Reserve is responsible for monetary policy in the United States.

Click here for an introduction to the Federal Reserve System from the St. Lous Fed.

organization:

1. District Banks
2. Board of Governors (chairman is Alan Greenspan)
3. Federal Open Market Committee

Tools of Monetary Policy

1. open market operations

Open market operations is the buying and selling of government bonds by the Federal Reserve. When the Federal Reserve buys a government bond from a bank, that bank acquires money which it can lend out. The money supply will increase. An open market purchase puts money into the economy.

2. discount rate

When the Federal Reserve makes a loan to a member bank, the loan is called a discount loan. The interest rate on a discount loan is called the discount rate.

Lowering the discount rate encourages banks to take out more discount loans while raising the rate discourages banks from borrowing from the Fed. Therefore, lowering the discount rate puts money into the economy; raising the discount rate takes money out of the economy.

3. reserve ratio

The reserve ratio is the percentage of deposits banks are required to hold as vault cash and not loan out.. Lowering the reserve ratio allows banks to loan out a greater fraction of deposits and the money supply would increase. Raising the reserve ratio would cause the money supply to shrink.

Expansionary Monetary Policy

To increase the money supply, the Federal Reserve can

• buy government bonds (an open market purchase)
• lower the discount rate
• lower the reserve ratio

Expansionary monetary policy is appropriate when the economy is in a recession and unemployment is a problem.

Changes in the money supply affect the economy through a 3 step process.

1. an increase in the money supply causes interest rates to fall
2. the decrease in interest rates causes consumption and investment spending to rise and so aggregate demand rises
3. the increase in aggregate demand causes real GDP to rise

Contractionary Monetary Policy

To decrease the money supply, the Federal Reserve can

• sell government bonds (an open market sale)
• raise the discount rate
• raise the reserve ratio

Contractionary monetary policy is appropriate when inflation is a problem.

1. a decrease in the money supply causes interest rates to rise
2. the increase in interest rates causes consumption and investment spending to fall and so aggregate demand falls
3. the decrease in aggregate demand causes real GDP to fall

What happens when the Fed sells securities on the open market?

When the Federal Reserve buys government securities on the open market What effect does this action have on the nation's money supply and aggregate demand?

What happens when the Federal Reserve sells government bonds?

How do open market sales affect interest rates?