Question

When the Fed wants to contract the money supply through open market operations, what would it do with the government bonds and what would happen to the reserves the Fed or the member banks hold?

Answer 1

Open market operations are the most widely used monetary-policy mechanism in the US. Open market operations occur when US sells or purchases by the central bank. Treasury bonds for controlling the volume of bank reserves and interest rate rates. Federal funds rate is the basic interest rate targeted in open market operations. The term is a bit of a misnomer, as the federal funds rate is the interest rate paid by commercial banks making loans to other banks overnight. As such, it is a very short-term interest rate but one that very well reflects financial market credit conditions.

Government securities sales minimize the funds available for lending, and continue to lift the federal funds rate. Policymakers call it tightening monetary policy, or contractionary policy. Again, if the economy were a car and the FOMC were its owner, the contractionary policy would be like taping the brakes lightly not enough to halt the vehicle, but just slow its momentum a little bit.

To control economic efficiency the FOMC uses free market operations such as an accelerator and brake pedal. The FOMC aims to provide the monetary stimulus required for a stable economy by adjusting the federal funds rate. The target for the federal funds rate is revealed to the public after each FOMC meeting.

A second method of conducting monetary policy is for the central bank to increase or lower the reserve requirement which, as we mentioned earlier, is the percentage of deposits made by each bank that it is legally needed to keep either as cash in its vault or on deposit with the central bank. If banks have to keep a greater sum of deposits, they have less capital to lend out. If banks are permitted to keep a smaller sum of reserves, they'll have more money to lend out. Larger adjustments in reserve ratios are seldom used in practice to enforce monetary policy. A sudden demand for all banks to raise their reserves would be highly disruptive and difficult to satisfy, thus loosening too much criteria would pose a danger that banks would not be able to meet the demand for withdrawals.