The Story of the Federal Reserve System Part 5: Open Market Operations

Last weeks Friday Funnies looked at the negative consequences of inflation. This week’s comic examines one of the Federal Reserves tools, open market operations to lower the federal funds rate.

So to try to prevent both recess and inflation, the Fed has three main monetary policy tools: open market operations, reserve requirements, and the discount rate.
So to try to prevent both recess and inflation, the Fed has three main monetary policy tools: open market operations, reserve requirements, and the discount rate.
Open market operations are purchases and sales by the Fed of U.S. government securities, which are large IOUs of the federal government. When the Fed buys securities, it pays for them by crediting the amount of the purchases to the account that the seller's bank has at the Fed. The bank, in turn, credits the seller's account.
Open market operations are purchases and sales by the Fed of U.S. government securities, which are large IOUs of the federal government. When the Fed buys securities, it pays for them by crediting the amount of the purchases to the account that the seller’s bank has at the Fed. The bank, in turn, credits the seller’s account.
We have more to lend now that the Fed has bought some government securities and the proceeds have been deposited in the bank.
Thus, open market purchases by the Fed provide the banking system with additional funds to lend.
Federal Funds Rate down
In that way, open market purchases tend to lower the federal funds rate, the interest rate that banks charge each other on very short-term loans.
Now that the bank doesn't have to pay as much to acquire funds, we can charge you a lower interest rate, too.
A drop in the federal funds rate can lead to a decline in the rates that banks can charge on loans and pay on deposits.
Now that interest rates have fallen, we can afford the construction project we've been talking about.
And, when interest rates fall, spending in the economy eventually increases.

Next week we’ll cover what happens when the Fed does the opposite and sells government securities.

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