Financing American government

5 Open market operations

Prior to 2008, the Fed implemented monetary policy by conducting open market operations. That is, the central bank decided on a target for the fed funds rate based on its judgment about aggregate demand in relation to its mandate, and adjusted the purchase or sale of treasuries to meet this target.

expansionary open market operation

The purchase of government securities in the open market by the Federal Reserve. This action is taken to decrease interest rates in the economy.

contractionary open market operation

The sale of government securities in the open market by the Federal Reserve. This action is taken to increase interest rates in the economy.

If the Fed chooses to conduct expansionary open market operations, it lowers interest rates by purchasing treasuries on the open market. For instance, if it purchases treasuries from banks, it deposits reserves to their accounts at the Fed Banks, and therefore ends up holding more reserves (base money). The increased supply of reserves lowers rates in the fed funds market and allows banks to lower the rates they charge on loans to businesses and households, including mortgage loans.

Instead, if the Fed chooses to increase interest rates, it sells treasuries, and hence runs a contractionary open market operation. The reduced supply of reserves raises rates in the fed funds market, and this is passed on to borrowers through higher rates on loans.

Expansionary open market operations work well under normal conditions but can fail to be effective if interest rates are already close to zero (and therefore cannot be pushed down further). In fact, this condition has held for much of the period since the global financial crisis of 2008, so the Fed has shifted to an alternative mechanism for influencing the fed funds rate—by paying and adjusting interest rates on reserves held at the Fed by commercial banks.