ECON-215: Targeting Weakness Areas - Open Markets Operations & Federal Funds Rate

Effect of Open Market Purchase on Reserve Supply

The supply of reserves increases, shifting the supply curve to the right.

Effect of Open Market Purchase on Federal Funds Rate

The federal funds rate falls (decreases).

Mechanism of Open Market Purchase

The Federal Reserve buys government bonds from banks/dealers and pays by crediting their reserve accounts, injecting money into the system.

Definition of Federal Funds Rate

The interest rate at which depository institutions (banks) lend reserve balances to other depository institutions overnight.

Why the Supply Curve Shifts Right

The Fed's purchase adds new reserves to the banking system that did not exist before, increasing the total quantity available at any given interest rate.

Market for Reserves: Y-Axis

The Federal Funds Rate (Price of borrowing reserves).

Market for Reserves: X-Axis

The Quantity of Reserves.

Relationship between Reserve Quantity and Federal Funds Rate

Inverse relationship; as the quantity of reserves increases (supply shifts right), the price to borrow them (the rate) decreases.

Type of Monetary Policy: Open Market Purchase

Expansionary Monetary Policy.

Impact on Demand Curve for Reserves during OMO Purchase

The demand curve does not shift; the equilibrium moves along the stable demand curve to a lower interest rate.

Primary Goal of Open Market Purchase

To lower interest rates and stimulate economic activity by increasing liquidity.

Market pressure created by Excess Supply of Reserves

Downward pressure on the federal funds rate as banks try to lend out their excess reserves.

Reverse Scenario: Open Market Sale

The Fed sells bonds, draining reserves, shifting supply left, and raising the federal funds rate.

Cost of Borrowing Reserves

Determined by the intersection of reserve supply and reserve demand; falls when supply increases.

Effect on Bank Balance Sheets (Assets)

Banks exchange securities (bonds) for reserves (cash equivalents); total assets change composition toward more liquid reserves.

Buying vs. Selling Bonds (Fed Perspective)

Buying puts money IN to the system (lowers rates); Selling takes money OUT of the system (raises rates).

Logic: Scarcity and Price

When the Fed makes reserves less scarce (by buying bonds), the 'price' of those reserves (the interest rate) goes down.

Who receives the funds from the Fed?

The sellers of the bonds, typically primary dealers or banks, receive credits to their reserve accounts at the Fed.

Link between Bond Prices and Interest Rates

When the Fed buys bonds, demand for bonds rises, bond prices rise, and consequently, interest rates (yields) fall.

Liquidity Effect

Open market purchases increase the liquidity in the banking system, encouraging lending.