Can You Explain The Concept Of Open Market Operations?

The Federal Reserve's most useful tool is open market operations. By selling or buying government securities in the open market, the Fed can lower or raise bank reserves. These so-called open market operations are a central bank's most important stabilizing instrument.

In setting policy, the FOMC decides whether to pump more reserves into the banking system by buying Treasury bills and longer term government bonds or whether to tighten monetary policy by selling government securities.

To see how an open market operation changes reserves, let us suppose that the Federal Reserve thinks the economic winds are blowing up a little inflation, as happened in early 1994. The FOMC holds it's meeting in Washington and hears presentations and projections from its staff of talented economists. The committee decides, "Let's sell $1 billion of Treasury bills from our portfolio to contract reserves and tighten overall money and credit." The motion is unanimously approved by vote of the seven Washington governors and five regional Bank presidents.

To whom are the bonds sold? To the open market. This includes dealers in government bonds, who then resell them to commercial banks, big corporations, other financial institutions, and individuals.