How Do Open Market Operations Affect the U.S. Money Supply?

The U.S. Federal Reserve conducts open market operations by buying or selling bonds and other securities to control the money supply. With these transactions, the Fed can expand or contract the amount of money in the banking system and drive short-term interest rates lower or higher depending on the objectives of its monetary policy.

Key Takeaways

  • The Federal Reserve buys and sells government securities to control the money supply and interest rates. This activity is called open market operations.
  • The Federal Open Market Committee (FOMC) sets monetary policy in the United States, and the Fed's New York trading desk uses open market operations to achieve that policy's objectives.
  • To increase the money supply, the Fed will purchase bonds from banks, which injects money into the banking system.
  • To decrease the money supply, the Fed will sell bonds to banks, removing capital from the banking system.
  • Open market operations have played a key part in navigating recent economic downtowns including the 2008 Global Financial Crisis and the COVID-19 recession.
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Open Market Definition

The Importance of Open Market Operations

Open market operations are one of three key tools the Federal Reserve uses to achieve its policy objectives. The objective of open market operations is to change the reserve balances of U.S. banks and cause reactionary changes to prevailing interest rates.

The Fed can increase the U.S. money supply by buying securities. Using newly created money, the Fed can go to the market, inject this capital into U.S. banks, and apply downward pressure on market interest rates as lenders now have more money to distribute as credit. The Fed can also decrease the U.S. money supply by doing the opposite. By selling securities it is holding on its balance sheet, the Fed can extract capital from bank reserves and decrease the amount of funds banks have available to lend.

Open market operations are important as it attempts to guide the direction of the economy. When the Fed is buying securities and increasing the money supply, the Fed is attempting to stimulate economic growth. This typically has a ripple effect of increased inflationary pressure, higher economic growth, higher employment, and generally greater economic prosperity for citizens and companies.

Open market operations also signal when the Fed believes inflationary pressure has gotten too high and the economy needs to contract. By selling securities, the Fed attempts to raise rates, slow economic growth, and stem inflation. Unfortunately, contractionary economic periods like this also traditionally cause increases in unemployment. It also makes obtaining credit more expensive for companies and citizens.

The Role of the Federal Open Market Committee

The Federal Open Market Committee (FOMC) sets monetary policy in the United States with a dual mandate of achieving full employment and controlling inflation. The committee holds eight regularly scheduled meetings each year, though emergency sessions may be called.

During these meetings, the FOMC determines whether to increase or decrease the money supply in the economy. This decision is driven by the FOMC's long-term goals of price stability, sustainable economic growth, and prevailing market conditions. The New York Fed's trading desk then conducts its market operations with the aim of achieving that policy, buying or selling securities in open market operations.

Expanding the Money Supply to Fuel Economic Growth

During a recession or economic downturn, the Fed will seek to expand the supply of money in the economy with a goal of lowering the federal funds rate—the rate at which banks lend to each other overnight.

To do this, the Fed trading desk will purchase bonds from banks and other financial institutions and deposit payment into the accounts of the buyers. This increases the amount of money that banks and financial institutions have on hand, and banks can use these funds to provide loans.

Example of Money Supply Growth

In response to COVID-19, the Federal Reserve began buying securities to inject liquidity and money into financial markets. By the end of 2020, the Fed's balance sheet has grown to $7.4 trillion, the highest level on record.

With more money on hand, banks will lower interest rates to entice consumers and businesses to borrow. With more money on hand, consumers will theoretically consumer more, increase investing, and buy more major purchases. For companies, greater access to money theoretically means greater opportunities to expand, increase headcount, or pay off existing debt obligations.

Contracting the Money Supply to Stabilize Prices

The Fed will undertake the opposite process when the economy is overheating and inflation is reaching the limit of its comfort zone. When the Fed sells bonds to the banks, it takes money out of the financial system, reducing the money supply.

Example of Monetary Contraction

By the end of 2021, the Federal Reserve was faced with rapidly escalating inflation and a booming economy. To try and preserve price stability, The Fed announced it would begin tapering its purchase of Treasury securities. Starting December 2021, the Fed began buying $10 billion less Treasury securities each month and $5 billion of agency mortgage-backed securities each month.

This will cause interest rates to rise, discouraging individuals and businesses from borrowing. In theory, consumers will spend, consumer, borrow, and invest less. It will also become more expensive for companies to expand. The impact of both outcomes is to slow inflation and economic growth, though the downside risk is an increase in unemployment.

Open Market Operations and Quantitative Easing

The Fed's open market operations were largely obscure to the public until the 2007-2008 Global Financial Crisis. The Fed undertook an unprecedented level of asset purchases via open market operations from the end of 2008 through October 2014. During this time the federal funds target rate was kept at a historically low range of 0% to 0.25%. At the end of this period the Fed's asset holdings had reached $4.5 trillion—five times the pre-crisis levels.

The Fed also undertook a similar but different method of influencing the economy called quantitative easing. This broad term is another method of injecting money into the economy to promote economic growth. However, quantitative easing often entails purchasing riskier assets, injecting capital at predetermined times, or pre-committing to buy a specific amount of assets over a period of time.

The primary difference between open market operations and quantitative easing is the underlying assets being purchased by the Fed. Open market operations entail the purchase of safer, shorter-term securities. Quantitative easing consists of buying long-term maturity securities, private assets, corporate debt, or asset-backed securities.

During major financial crises, the Fed will often enact open market operations at the same time as quantitative easing. For example. from December 2008 to March 2010, the Fed purchased $175 billion in agency securities and $1.25 trillion of mortgage-backed securities. It also purchased $600 billion of long-term Treasury securities from November 2010 to June 2011. These untraditional quantitative easing methods had the same intention of promoting economic growth.

How Does the Fed Use Open Market Operations to Increase the Money Supply?

The Fed uses open market operations to buy or sell securities to banks. When the Fed buys securities, they give banks more money to hold as reserves on their balance sheet. When the Fed sells securities, they take money from banks and reduce the money supply.

What Is the Difference Between Money Supply and Monetary Base?

The monetary base only includes money in circulation and cash reserves held at banks - it is limited to only the most liquid funds. The monetary base is one of three standard measures of the money supply (including the M1 money supply and M2 money supply).

What Is an Example of Open Market Operations?

In 2020, the Federal Reserve announced it would begin monthly purchases of Treasury and other securities. The goal of these purchases would be to increase the reserves of banks and promote economic activity during COVID-19.

The Bottom Line

Whether the Fed wants to stimulate or cool economic growth, one of its most important tools is open market operations. The Fed's buying or selling of securities has ripple effects through the money supply, interest rates, economic growth, and employment.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Federal Reserve System. "Federal Open Market Committee."

  2. New York Fed. "Open Market Operations During 2020."

  3. Board of Governors of the Federal Reserve System. "Federal Reserve Issues FOMC Statement."

  4. Federal Reserve System. "The Federal Reserve's Response to the Financial Crisis and Actions to Foster Maximum Employment and Price Stability."

  5. Federal Reserve System. "The Federal Reserve's response to the financial crisis and actions to foster maximum employment and price stability."

  6. Federal Reserve System. "Recent balance sheet trends."

  7. Federal Reserve Bank of St. Louis. "Quantitative Easing: How Well Does This Tool Work?"

  8. Federal Reserve System. "FAQs."

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