Open market operations refers to a process by which a division of the Federal Reserve buys and sells government securities to set the money supply. If the FOMC wants to increase the money supply in the economy it will buy securities. Conversely, if the FOMC wants to decrease the money supply, it will sell securities.
Let's break down the process and explain the rationale behind it. Formulating a country's monetary policy is extremely important when it comes to promoting sustainable economic growth. More specifically, monetary policy focuses on how a country determines the size and rate of growth of its money supply in order to control inflation within the country.
In the United States, a committee within the Federal Reserve is responsible for implementing monetary policy. This group, the Federal Open Market Committee (FOMC), is comprised of the Fed's Board of Governors and five reserve bank presidents, and it 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. The government securities that are used in open market operations are Treasury bills, bonds, and notes.
To increase the money supply in the market, the FOMC will purchase these securities from banks. The funds that the banks acquire from the sale can be used as loans to individuals and businesses. The more money that is available in the market for lending, the lower the rates on these loans become, which causes more borrowers to access cheaper capital. This easier access to capital leads to greater investment and will often stimulate the overall economy.
To decrease the money supply, the FOMC will sell these securities to banks, which leads to money being taken out of the banks and kept in FOMC reserves. The decrease in money available in the economy leads to a decrease in investment and spending as the availability of capital decreases and it becomes more expensive to obtain. This limiting of access to capital slows down economic growth as investment decreases.
The FOMC also sets a target federal funds rate and uses open market operations to adjust the supply of reserve balances to achieve that target. It adjusts this rate periodically, usually each quarter.