Monetary Policy Instrument #3: open market operations

Monetary Policy Instrument #3: open market operations

The most frequently used instrument of monetary policy is open market operations. Open market operations are the purchases and sales of government securities by the Federal Open Market Committee (FOMC).

Open market purchases of government securities increases the money supply (expansionary monetary policy).
· If the Fed buys government securities, then the monetary base increases and banks end up with more excess reserves.
· Banks typically will use these excess reserves to make more loans.
· More loans mean the money supply is larger.
· A larger money supply means interest rates decrease.
· Lower interest rates encourage investment spending by businesses and consumer spending (especially on large items, such as houses and cars).
· Increased investment (I) & consumption spending (C) mean increased aggregate demand. (AD = C + I + G + X - M)

Open market sales of government securities decreases the money supply (contractionary monetary policy).
· If the Fed sells government securities, the monetary base decreases and banks end up with fewer excess reserves.
· Fewer excess reserves imply that banks typically will reduce the quantity of money they lend.
· Less money loaned means the money supply is smaller.
· A smaller money supply means interest rates increase.
· Higher interest rates discourage investment spending by businesses and consumer spending (especially on large items, such as houses and cars).
· Reduced investment (I) & consumption spending (C) mean reduced aggregate demand. (AD = C + I + G + X - M)[8]