Open Market Operations Term Paper

  • Length: 15 pages
  • Subject: Economics
  • Type: Term Paper
  • Paper: #42753242

Excerpt from Term Paper :

Open Market Operations

Monetary policy may involve several facets, including reserve requirements, discount rate and interest rate targeting. The U.S. Federal Reserve's long-time strategy has been to use interest rate targeting through Open Market Operations primarily to keep the economy in its attempts to keep the economy in a state of equilibrium.

Today, open market operations (purchase and sale of U.S. Treasury and other federal agency securities) are the principal tool used by the Federal Reserve in implementing monetary policy (Federal Reserve Web site). The Federal Open Market Committee (FOMC) of the Federal Reserve decides on the short-term objective, an objective that can be either a desired quantity of reserves of a desired price, also called the federal funds rate; this, in turn, will have the effect of making interest rates increase or decrease. "The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight" (Federal Reserve Web site), which allows it to either slow down or heat up the economy, but at a slight remove from the direct action of other actions, such as manipulating the discount rate.

If the FOMC decides it want the funds rate to fall -- the interest rate to decrease -- it buys government securities from a bank, and pays for them by increasing that bank's reserves. "As a result, the bank now has more reserves than it wants. So the bank can lend these unwanted reserves to another bank in the federal funds market. Thus, the Fed's open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls" (Federal Reserve Web site). It the Fed wants the rates to rise, it reverses this, lowering the supply of reserves in the system, making funds rates -- and eventually commercial interest rates -- rise.

It is easy to see that this is a fairly indirect route to ramping up or damping down the economy, dependent not only on what the Fed wants, but what the commercial market -- U.S. industry and consumers -- want. It could be regarded as a more holistic approach, therefore, than others in which the Fed would directly pump money into or siphon it out of the commercial market.

Considering the longevity of Federal Reserve Chairman Alan Greenspan, it is likely that the preference for open market operations as the regulator of the nation's economy via interest rate 'soft manipulation' of this sort has been strengthened during his tenure. However, the United States FOMC preference for an open market operations approach to monetary policy predates Mr. Greenspan. It is equally likely that there are some cogent reasons for the policy having been instituted in the first place, and for its continuing despite calls by some for using reserve requirements or the discount rate instead to perform the same function. Arguably, using the 'invisible' method of Federal Reserve bank internal lending is likely to lead to more stability in financial markets.

Long history of FOMC voting behavior: Personality preference?

Chappell & McGregor (2000) analyzed the voting records of 84 Federal Open Market Committee (FOMC) members who served during a 30-year period, from 1966-1996, longer even than the influence of Mr. Greenspan.

United States monetary policy decisions, despite the influence of the Federal Reserve Chairman, even one as influential as Mr. Greenspan, are made by the Federal Open Market Committee. The FOMC guides monetary policy through directives composed by a committee composed of the seven members of the board of governors and five out of twelve district Federal Reserve Bank presidents. The FOMC is not a single agent, like the chairman, whose preferences might change slowly, if at all. On the contrary, the FOMC can be viewed as a group with an aggregation of preferences, making it all the more astonishing that the preferred policy has held for so long. The directives of this group must be approved by a majority vote at regular meetings, however: whether this works to enhance relative immutability or to diminish it seems fairly clear. In view of the fact that monetary policy has not changed appreciably for more than two decades, the full member vote would seem to be either a rubber stamp, or an indication that the top executives of United States federal banking institutions are remarkably in tune with each other.

There are other reasons for the apparent consistency of the group in continuing to choose open market operations/interest rate targeting to fine-tune the economy. Discussions of monetary policy at the Fed usually begin with a report from the staff covering economic forecasts and outlining alternative policy options to those in place at the time. Members then comment and there is general discussion. The chairman, or a member chosen by the chairman, proposes wording for the policy directive to come out of the meeting. Chappell & McGregor (2000) note that the chairman plays a major role in directing policy in two ways. First, through his influence on the language of the policy, he may be able to shift it in a direction he favors, in a way, subliminally influencing the reaction of the full committee. Second, that may be 'gravy' as the chairman may have already influenced the content of the staff report beforehand. According to Chappell & McGregor (2000), the chairman has both consensus-building and agenda-setting powers; it may be, then, that all that is needed to determine why the FOMC has a long preference for Open Market Operations is to look at the biases and rationales of the chairmen, vis-a-vis the U.S. economy.

It should not be suggested, however, that there is never any dissent within the FOMC. "In the past, differences among the governors and the bank presidents have led to widely publicized conflicts within the FOMC over whether to respond more actively to a sluggish U.S. economy" (Chappell & McGregor 2000, 407ff), that is, whether to return to a more activist stance than the open market operations approach allows.

In fact, during 1992, during the term of office of the first Mr. Bush as president, three of the governors were prepared to manipulate the discount rate in order to mitigate some of the effects of the economic slowdown. Two others, at the time, were worried that the Fed had already lowered rates too much and eased monetary policy too far (Chappell & McGregor 2000, 407ff). It did not happen, however, because by requiring directives be the result of committee consensus, such changes are also slow in coming unless pushed forward by the chairman through his considerable influence, as noted above.

Despite all these factors indicating that consensus would be the likely outcome in almost all cases, Chappell & McGregor (2000) also documented "the considerable diversity in policy preferences of FOMC members over the 1966-1996 time period" (Chappell & McGregor 2000, 407ff). Despite this, Chappell & McGregor concluded that accurately describing the forces underlying policy choices by the FOMC would, eventually, be useful to ensure high ethical behavior by politicians. They noted, however, that despite the dissent, the policy did not change.

By 2004, Chappell, writing with McGregor and Vermilyea, was ready to claim that although decisions are "formally majoritarian" at the Federal Reserve FOMC, "the Board Chairman has often been portrayed by the media as a monetary policy dictator" (Chappell et al. 2004, 906).

In May, 1982, U.S. News and World Report listed Fed Chairman at the time Paul Volcker as the second most powerful person in the United States. In addition, the academic literature on monetary policy making suggested a very prominent role for the chairman. Woolley, noted Chappell et al., made the connection between the person and power of the chairman of the Federal Reserve, and monetary policy decisions, noting that "the Chairman's roles as liaison with external clients and resource allocator within the Fed give him leverage over the FOMC, and other research has documented both the influence of various Chairmen on monetary policy decisions and the factors that have shaped their policy positions" (Chappell et al. 2004, 906).

In their earlier study, Chappell and McGregor (2000) suggested that there was internal dissent in the FOMC. However, by 2004, they note that internal consensus -- or at least, the consensus arrived at in the process of issuing policy directives -- gives the Fed "power and credibility in dealing with external clients, including the President, the Congress, and the public" (Chappell et al. 2004, 906). In setting the policy favoring Open Market Operations, however, the Chairman's preference still dominates. Chappell et al. note:

Although the need to garner majority support and achieve consensus may sometimes limit the power of the Chairman, the presence of an ethic favoring consensus might accentuate it. For example, if members are reluctant to challenge proposals offered by an agenda-setting Chairman, then he may be able to tilt outcomes toward his favored positions (Chappell et al. 2004, 906).

It would appear that while the preferences of any given set of Fed governors and Reserve Bank presidents…

Cite This Term Paper:

"Open Market Operations" (2005, April 20) Retrieved January 18, 2017, from

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"Open Market Operations", 20 April 2005, Accessed.18 January. 2017,