The Federal Reserve's open market operations and quantitative easing policy

Macroeconomic Forecasting

Federal Reserve Policy

The Federal Reserve through open market operations can be a net seller or buyer of U.S. Treasuries. As a net seller of bonds the Fed is enacting policy which will tighten the money supply taking money out of circulation. The policy is conducted as follows: The Federal Reserve Open Market Committee instructs the trading desk at the New York Federal Reserve Bank to sell a specified amount of their holdings of U.S. Treasuries. In doing so, investors will purchase these bonds from the FED through their currency or bank deposits, thereby reducing the amount of dollars held by the investor. The transaction reduces the money supply by a reduction in currency held by the public and reduced bank deposits. Consequently, banks will have fewer deposits and as a result "find themselves with a smaller quantity of reserves. In response, banks reduce the amount of lending, and the process of money creation reverses itself" (Mankiw, G. 2004).

Banks earn a rate of return on their reserve holdings by lending them overnight to other banks in need of reserves to meet requirements; this rate is known as the Fed Funds Rate. Succinctly then "Fed open market operations change the supply of reserve balances in the system, and by affecting the supply of balances, the Fed can create upward or downward pressure on the fed funds rate" (Federal Reserve Bank of New York. N.D.). In the case of the Fed as a net seller of bonds the fed funds rate will be increased. As a result other interest rates: prime rate, commercial paper rate, and bank lending rates tend to move in step or in expectation of the fed funds rate. The increase in interest rates coupled with reduced bank lending will have a dampening effect on economic growth.

The obverse process finds the Fed as net buyers of treasuries, resulting in the increase in currency and bank deposits held by investors. Banks will have increased reserves, a portion held according to reserve requirements, the reminder loaned or invested. Both by currency holdings increased and greater reserves for banks to utilize, the money supply increases. Concomitantly, the fed funds rate will decline as will other interest rates in tandem, and the impact of increase money supply will spur economic growth.