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Jon has taught Economics and Finance and has an MBA in Finance
In early November 2010, an article from the National Journal summarized the weak state of the national economy, burdened with high unemployment, and then outlined the central bank's prescription to encourage economic growth. The article said this:
'The Federal Reserve, in a much-anticipated attempt to rev up the economy and fend off deflation, launched a new program this afternoon to inject $600 billion into the economy... the policy-setting Federal Open Market Committee said it will create $75 billion in new dollars per month through next June and use them to buy long-term Treasury bonds. The goal is to push down the cost of borrowing for both businesses and consumers, and in turn to increase investment and spending.
In addition, the committee said it would continue to reinvest the proceeds from maturing mortgage-backed securities into Treasury bonds, effectively pumping what is expected to be an additional $250 billion to $300 billion into the economy at large.'
The Federal Reserve is the central bank of the nation, and it's solely responsible for controlling the supply of money in the economy - what economists refer to as 'monetary policy.' Just as this article suggests, monetary policy actions that increase the money supply lead to higher economic output as measured by real GDP.
The Fed uses three main tools that it calls open market operations, required reserves and the discount rate. This lesson covers the first one, open market operations. Let's find out what open market operations are, how they work and then see the effect that they have on the money supply using some real-world examples.
In the town of Ceelo, three people are very interested in what the Federal Reserve is doing: Lydia (a factory worker), Bob (a business owner) and Allison (a retired woman living on Social Security and the savings she has at the bank). Each of them are anxiously awaiting the announcement taking place today by the central bank - an announcement that will affect interest rates and the economy as well as impact them on a personal level.
Open market operations are the purchases and sales of government securities in the open market by the Federal Reserve. According to the New York Federal Reserve, which conducts these activities throughout the year, open market operations are the most flexible and frequently used means of implementing U.S. monetary policy.
The Federal Open Market Committee (or FOMC for short) is directly responsible for all open market operations. It's made up of seven Federal Reserve governors plus five Federal Reserve district bank presidents.
Whenever I hear the words 'open market operations,' I imagine a patient in the hospital about to be wheeled in to have open-heart surgery performed. In the physical body, the blood carries oxygen to keep the body alert and strong, and the heart is responsible for pumping this supply of oxygen-rich blood throughout the veins and arteries. Sometimes the heart gets blocked, and this supply can't flow where it's needed. Open heart surgery unblocks the heart so that it can pump the supply of blood needed for survival and good health.
The money supply is the lifeblood of the economy, and the open market operations conducted by the Federal Reserve take place at the heart of the financial system. Their activities ensure that the supply of money flows freely into the hands of consumers and businesses who can use it to invest and make the economy grow.
Why does the Fed want to control the money supply? Because it enables them to control the most basic interest rate in the economy: the federal funds rate. The federal funds rate is the interest rate that banks charge other banks for overnight loans; therefore, it is the most short-term of all the interest rates. When the Fed changes the money supply and alters this most basic interest rate, they indirectly affect all other interest rates. This is what gives them the ability to stimulate economic growth or slow the economy down.
For example, if the Fed buys government securities, they pay with new money that gets added to the reserves of the banking system. This increase in the money supply causes the fed funds rate to go down - let's say from 4% to 3%. Why does that matter? Almost immediately, interest rates on many other financial investments in the economy would go down as well, which means that the Fed has just lowered the price of money for consumers and businesses. Interest rates on credit cards, home equity loans and business loans begin to fall, making it cheaper to borrow, and this in turn stimulates the economy. At the same time, interest rates on savings accounts fall.
In the town of Ceelo, Lydia, the factory worker, can now take out a home equity loan and upgrade her kitchen - a project she's been wanting to pursue for a long time. Bob, the business owner of a lawn service, finds it cheaper to borrow money to invest into his business. These people are happy about lower interest rates.
However, people like Allison are not. Allison depends not only on Social Security checks she receives each month, but on the interest she earns in her large savings accounts at the bank. When interest rates go down, Allison earns a lower return, which lowers her income. She's very disappointed to hear this news. Borrowers love it and savers hate it when interest rates go down, something that happens when the Federal Reserve buys bonds in the open market.
On the other hand, when the economy is growing too quickly and inflation is going up, the Federal Reserve may conduct open market operations by selling government securities, leading to an increase in the fed funds rate, which trickles down to many of the other rates that affect consumers and businesses. In this case, interest rates on credit cards, home equity loans and business loans would rise, creating less of an incentive for consumers and businesses to borrow money. This, in turn, slows down the economic output of the nation. However, interest rates on savings accounts would rise, benefiting savers. Borrowers hate it when interest rates go up, but savers love it.
Although the Fed does not control the demand for money, by controlling the supply of money in the money market, it can set the interest rate wherever it wants in order to stimulate growth in the economy or slow the economy down. Let's take a closer look at what happens to the money supply when the Fed conducts its open market operations.
Suppose the reserve requirement set by the Fed is 20% (we'll talk more about this in a few minutes). Now suppose the Federal Reserve makes an open market purchase of $500,000 of U.S. government bonds.
The question we want to answer is this: what is the maximum amount that the money supply could increase by? First we take the reserve ratio, and we use it to calculate the money multiplier.
The formula for the money multiplier is this: money multiplier = 1/the reserve ratio.
The money multiplier is the reciprocal of the reserve ratio; in this case, it would be 1/20%, which is equal to 5.
The second formula we need tells us how much the money supply would change when open market operations are used. Here's that formula: change in money supply = change in reserves * the money multiplier.
So the maximum change in the money supply in this example would be: $500,000 * 5, which equals $2.5 million. When the Fed buys $500,000 worth of government bonds in the open market, the maximum amount that the money supply across the economy could increase would be $2.5 million.
So purchasing U.S. government bonds, otherwise known as 'government securities,' leads to an increase in the money supply. This is what the Federal Reserve does to increase the money supply.
Of course, the process works in reverse as well. When the Fed wants to decrease the money supply, they do so by selling government bonds to the public in the open market. The money used in this exchange gets removed from the banking system, so the money supply goes down.
For example, assume that the Federal Reserve decreases the monetary base by $10 billion when they purchase government bonds in the open market. The reserve requirement is currently 10%. What is the maximum amount the money supply could decrease?
We know that the increase in reserves is $10 billion. Now let's calculate the money multiplier using the reserve ratio of 10%.
So, money multiplier = 1/reserve ratio. Therefore, we have 1/10%. That means the money multiplier in this case is 10.
Plugging it into the second formula, we get: change in money supply = change in reserves * money multiplier, or the maximum change in the money supply would equal $10 billion x 10 = $100 billion.
Open market operations are one of the most common activities performed by the Federal Reserve. Now you know more about these open market operations and how to calculate the change in the money supply when the Fed buys or sells government securities.
Time to review. The Fed uses three main tools to increase or decrease the money supply that it calls open market operations, required reserves and the discount rate.
Open market operations are the purchases and sales of government securities in the open market by the Federal Reserve.
When the Fed wants to increase the money supply, they do so by purchasing government bonds from the public in the open market. The cash they use to buy these bonds is new money that gets added to the reserves of the banking system, so this increases the money supply.
When the Fed wants to decrease the money supply, they do so by selling government bonds to the public in the open market. The money used in this exchange gets removed from the banking system, so the money supply goes down.
The formula used to calculate the money multiplier is as follows: money multiplier = 1/the reserve ratio.
Here's the formula used to calculate changes in the money supply: change in money supply = change in reserves * the money multiplier.
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