Because the Federal Reserve can influence the interest rates at which banks borrow, it can influence the behavior of banks. Open-Market Operations In the memo with which we opened the chapter, the Federal Open Market Committee (FOMC) decided to increase the target federal funds rate to 2.5 percent. But what exactly does this mean, and how did the Fed accomplish it? The federal funds rate is the interest rate in a particular market—the market where banks make overnight loans to each other. Overnight loans, as the name suggests, are assets that have a very short time to maturity (one day). The interest rate on these loans is therefore one of the “shortest” interest rates in the economy, which is why it is targeted by the Fed. The interest rate is so named because the loans are made using the funds that banks have available in their accounts at the Federal Reserve. The Federal Reserve does not participate directly in this market. It influences the federal funds rate by buying and selling in a different market—the market for short-term government debt. These purchases and sales are called open-market operations. Let us examine how this works. The effect of open-market operations can be seen in the market for government debt. Part (a) of Figure 10.18 “The Market for Government Bonds”shows the supply and demand of this asset. The horizontal axis shows the quantity of assets (think of this as the amount traded on a given day), and the vertical axis shows the price of those assets. The participants in this market are financial institutions and others who hold, or want to hold, bonds as part of their portfolio of assets. Current owners will be willing to sell bonds if their price is sufficiently high. Conversely, if the price of bonds decreases, more people will want to purchase them. The same institution could be either a supplier or a demander, depending on the price. It is perfectly possible that a financial institution would want to buy bonds if their price were low and sell them if their price were high.
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