Open Market Operations

Open Market Operations – this is when the Fed either purchases or sells government securities (bonds) in the open market. This accomplishes two goals:

a. Increase or decrease the money supply. If the Fed purchases bonds from individuals or banks, those individuals or banks now have the cash to spend (the money received for the sale of the government bonds they’ve been holding. This injection of cash can help speed up an ailing economy. (The Fed would do the exact opposite if it were contracting the money supply – sell government bonds on the open market, taking cash out of the economy.

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b. Increase or decrease the interest rates throughout the economy. By purchasing bonds in the open market, the Fed is also decreasing interest rates throughout the economy. Here’s how it works:

i. Assume the face value of a government bond is $1000 with an interest rate of 6%. Whoever holds the bond gets $60 a year in interest (1000 x 6%). Note that $60 ÷ $1000 = 6%

ii. Now to entice bondholders to let the Fed purchase their government bonds, the Fed offers them a HIGHER price than the original $1000. Let’s say the Fed offers $1200 per bond.

iii. No matter what, the interest on the bond will always be 6% x $1000 = $60 (because that’s what’s printed on the bond. But look what’s happened to the EFFECTIVE interest rate throughout the economy)

iv. The interest received is still $60 after the purchase, but the amount paid for the bond is no longer $1000; it’s now $1200. The EFFECTIVE interest rate has gone from 6% to 5% ($60 ÷ $1200 = 5%).

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