How a Central Bank Executes Monetary Policy

Open Market Operations

The most common monetary policy tool in the U.S. is open market operations.These take place when the central bank sells or buys U.S. Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates. The specific interest rate targeted in open market operations is the federal funds rate. The name is a bit of a misnomer since the federal funds rate is the interest rate that commercial banks charge making overnight loans to other banks. As such, it is a very short term interest rate, but one that reflects credit conditions in financial markets very well.

The Federal Open Market Committee (FOMC) makes the decisions regarding these open market operations. The FOMC comprises seven members of the Federal Reserve’s Board of Governors. It also includes five voting members who the Board draws, on a rotating basis, from the regional Federal Reserve Banks. The New York district president is a permanent FOMC voting member and the Board fills other four spots on a rotating, annual basis, from the other 11 districts. The FOMC typically meets every six weeks, but it can meet more frequently if necessary. The FOMC tries to act by consensus; however, the Federal Reserve's chairman has traditionally played a very powerful role in defining and shaping that consensus. For the Federal Reserve, and for most central banks, open market operations have, over the last few decades, been the most commonly used tool of monetary policy.

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To understand how open market operations affect the money supply, consider the balance sheet of Happy Bank, displayed in Figure. Figure (a) shows that Happy Bank starts with $460 million in assets, divided among reserves, bonds and loans, and $400 million in liabilities in the form of deposits, with a net worth of $60 million. When the central bank purchases $20 million in bonds from Happy Bank, the bond holdings of Happy Bank fall by $20 million and the bank’s reserves rise by $20 million, as Figure (b) shows. However, Happy Bank only wants to hold $40 million in reserves (the quantity of reserves with which it started in Figure) (a), so the bank decides to loan out the extra $20 million in reserves and its loans rise by $20 million, as Figure(c) shows. The central bank's open market operation causes Happy Bank to make loans instead of holding its assets in the form of government bonds, which expands the money supply. As the new loans are deposited in banks throughout the economy, these banks will, in turn, loan out some of the deposits they receive, triggering the money multiplier that we discussed in Money and Banking.

The figure shows 3 t-accounts. T-account (a) has the following assets: reserves = 40; bonds = 120; loans = 300. T-account (a) has the following Liabilities: deposits = 400; net worth = 60. T-account (b) has the following assets: reserves = (40 + 20 = 60); bonds = (120 – 20 = 100); loans = 300. T-account (b) has the following liabilities: deposits = 400; net worth = 60. T-account (c) has the following assets: reserves = (60 – 20 = 40); bonds = 100; loans = (300 + 20 = 320). T-account (c) has the following liabilities: deposits = 400; net worth = 60.

Where did the Federal Reserve get the $20 million that it used to purchase the bonds? A central bank has the power to create money. In practical terms, the Federal Reserve would write a check to Happy Bank, so that Happy Bank can have that money credited to its bank account at the Federal Reserve. In truth, the Federal Reserve created the money to purchase the bonds out of thin air—or with a few clicks on some computer keys.

Open market operations can also reduce the quantity of money and loans in an economy. Figure (a) shows the balance sheet of Happy Bank before the central bank sells bonds in the open market. When Happy Bank purchases $30 million in bonds, Happy Bank sends $30 million of its reserves to the central bank, but now holds an additional $30 million in bonds, as Figure (b) shows. However, Happy Bank wants to hold $40 million in reserves, as in Figure (a), so it will adjust down the quantity of its loans by $30 million, to bring its reserves back to the desired level, as Figure (c) shows. In practical terms, a bank can easily reduce its quantity of loans. At any given time, a bank is receiving payments on loans that it made previously and also making new loans. If the bank just slows down or briefly halts making new loans, and instead adds those funds to its reserves, then its overall quantity of loans will decrease. A decrease in the quantity of loans also means fewer deposits in other banks, and other banks reducing their lending as well, as the money multiplier that we discussed in Money and Banking takes effect. What about all those bonds? How do they affect the money supply? Read the following Clear It Up feature for the answer.

The figure shows 3 t-accounts. T-account (a) has the following assets: reserves = 40; bonds = 120; loans = 300. T-account (a) has the following Liabilities: deposits = 400; net worth = 60. T-account (b) has the following assets: reserves = (40 – 30 = 10); bonds = (120 + 30 = 150); loans = 300. T-account (b) has the following liabilities: deposits = 400; net worth = 60. T-account (c) has the following assets: reserves = (10 + 30 = 40); bonds = 150; loans = (300 – 30 = 270). T-account (c) has the following liabilities: deposits = 400; net worth = 60.

Does selling or buying bonds increase the money supply?

Is it a sale of bonds by the central bank which increases bank reserves and lowers interest rates or is it a purchase of bonds by the central bank? The easy way to keep track of this is to treat the central bank as being outside the banking system. When a central bank buys bonds, money is flowing from the central bank to individual banks in the economy, increasing the money supply in circulation. When a central bank sells bonds, then money from individual banks in the economy is flowing into the central bank—reducing the quantity of money in the economy.

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