THE NUTS AND BOLTS OF MONETARY POLICY

Open-Market Operations

The Feds useful tool is “open-market operations.” selling or buying government in the open market, the Fed can lower or raise bank reserves, These so-called open-market operations are a central bank’s most important monetary-policy instrument.

In setting policy, the FOMe decides whether to pump more reserves into the banking system by buying Treasury bills (i.e. short-term bonds) and longer term government bonds or whether to tighten monetary policy by selling government securities. To see how an open-market operation changes reserves, let us suppose that the Fed thinks the economic winds (ire blowing up a little inflation, The FOMe holds its meeting in Washington and hears presentations and projections from its staff of talented economists. The committee decides to tighten money and credit by selling bonds. To whom are the in government bonds, who then resell them to commercial banks, big corporations. other financial institutions, and individuals.

The purchasers usually buy the bonds by writing checks to the Fed, drawn from an account in a commercial bank. For example, if the Fed sells $10,000 worth of bonds to Ms. Smith, she writes a check on the Coyote Bank of Santa Fe. The Fed presents the check at the Coyote Bank. When the Coyote Bank pays the check, it will reduce its balance with the Fed by $1.0,000. At the end of the day, the Coyote Bank, and the entire commercial banking system, will lose $10,000 in reserves at the Federal Reserve System. Table 26-2(a) shows the effect of a $1 billion open-market sale on the Federal Reserve balance sheet. The open-market sale changes the Federal Reserve balance sheet by reducing both assets and liabilities by $1 billion: the Fed has sold $1 billion of government bonds, and its liabilities have declined by exactly the same amount, SI billion of bank reserves.

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