How Do Open Market Operations Affect the U.S. Money Supply?

The Federal Reserve (Fed) buys and sells government securities to control the money supply. This activity is called open market operations (OPO). By buying and selling government securities in the free market, the Fed can expand or contract the amount of money in the banking system and pursue its monetary policy.

The Federal Open Market Committee (FOMC) is the Federal Reserve Committee that sets monetary policy in the United States. Formulating a country's monetary policy is important for sustainable economic growth. Monetary policy determines the size and rate of growth of a country's money supply in order to control inflation.

The FOMC is composed of the Fed's Board of Governors and five reserve bank presidents. The committee meets eight times throughout the year to set key interest rates and to determine whether to increase or decrease the money supply within the economy. Treasury bills, bonds, and notes are the government securities used in open market operations.

To increase the money supply, the Fed will purchase bonds from banks to inject money into the banking system. The banks can use these funds to provide loans to individuals and businesses. Greater loan activity reduces interest rates and stimulates the economy. If the Fed sells bonds to the banks, it takes money out of the financial system, which increases interest rates, reduces demand for loans, and slows the economy. The Fed uses this technique to adjust and manipulate the federal funds rate, which is the rate at which banks borrow reserves from one another. The FOMC adjusts the federal funds rate periodically, usually each quarter.

The Fed enacts an expansionary monetary policy when the FOMC aims to decrease the federal funds rate. The Fed purchases government securities through private bond dealers and deposits payment into the bank accounts of the individuals or organizations that sold the bonds. The deposits become part of the cash that commercial banks hold at the Fed. These larger deposits increase the amount of money that commercial banks have available to lend. Retail banks want to use their cash reserves for lending; thus, they try to attract borrowers by lowering interest rates, which includes the federal funds rate.

When the amount of funds available to loan increases, interest rates go down. A decrease in the cost of borrowing means that more people and businesses have access to funds at a cheaper rate. This leads to more spending and less saving by individuals, which fuels the economy leading to lower unemployment.

The Fed enacts a contractionary monetary policy when the FOMC looks to increase the federal funds rate and slow the economy. The Fed sells government securities to individuals and institutions, which decreases the amount of money left for commercial banks to lend. This increases the cost of borrowing and raises interest rates, including the federal funds rate.

When the cost of debt increases, individuals and businesses are discouraged from borrowing and will opt to save their money. Higher interest rates mean that the interest in savings accounts and certificates of deposit (CDs) will also be higher. To take advantage of the savings rates, entities will spend less in the economy and invest less in the capital markets, thereby, slowing inflation and economic growth.

The more money that is available in the open market for lending, the lower the rates on the loans become, which means more borrowers can access cheaper capital. This access to capital leads to greater investment and more spending and will often stimulate the overall economy.

A decrease in money available in the economy, which occurs when the Fed sells bonds to banks, leads to a reduction in investment and spending as the availability of capital decreases and it becomes more expensive to obtain loans. This limiting of access to capital slows down economic growth because spending and investment decreases.