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Open market operations

Open market operations

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Author: Kate Eskra
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This lesson covers the Open market operations
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Tutorial

OPEN MARKET OPERATIONS

Source: Image of Bureau of Engraving and Printing, creative commons, http://en.wikipedia.org/wiki/File:Bureau_of_Engraving_and_Printing,_entrance_-_Washington,_D.C..jpg, Image of Money Market Graph created by Kate Eskra, Image of Increase in Money Supply created by Kate Eskra, Image of Decrease in Money Supply created by Kate Eskra

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Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on open market operations. As always, my key terms are in red and my examples are in green.

In this tutorial, we'll start out by looking at how we can classify money according to how liquid it is into various components of our money supply, M0, M1, and M2. You'll see that the FOMC, or Federal Open Market Committee, is the organization in our country who manages and makes decisions about interest rates and then the supply of our money. You'll see also that open market operations are just one of the tools that the Fed has that controls how much money is in circulation.

So just as a quick reminder here, money is anything that serves as a medium of exchange, a store of value, and a unit of account. When most people think of money, they think of bills or coins. But if it's anything that allows us to get what we want, isn't it also checks and debit cards? What else could it potentially be?

Depending on how easy or difficult it is to go out and spend a certain type of money right now, we classify it accordingly. So some forms of money, like cash, are the easiest form of money to go out and spend right now. But other forms of money, like money I might have in my savings account, involve a few more steps in order for me to be able to spend it.

This idea is known as liquidity. So cash is extremely liquid. It's the most liquid form of money, because I can spend it right now. Money that's not so liquid are things like money in my savings account.

So when we use liquidity to classify it, we first start with M0, the nearest way of defining money, which is the most liquid. And this is just physical cash in circulation.

Then we move to M1, which includes M0. But it also includes now checking accounts. Still very liquid, right? You can write a check on your checking account. You can swipe your debit card on your checking account.

M2 is the one that's the least liquid, so it's our broadest definition of money. And this includes M1 and time deposits. Things that we refer to as time deposits are things like savings accounts or money market mutual funds. You can't spend the money right this second. But you can access it through going through a couple of steps.

So here are the official key terms for you, M0 being the narrowest definition of money, including only the stock of physical currency. M1, and now we're including our demand deposits, plus the M0. And M2, now we're including time deposits, like savings accounts and things like that, plus our M1.

OK. So our FOMC is the Federal Open Market Committee. They're part of the Fed. And they meet eight times a year to manage our nation's money supply.

They have various tools to try to control these various parts of our money supply, M0, M1, and M2. And the tools they have are the reserve requirement, open market operations, the Fed funds market, and the discount rate. But this tutorial now, we'd like to focus on open market operations. So let's talk about them.

Open market operations as your key term are defined as one of the mechanisms available to the Fed to regulate interest rates and the money supply. So these open market operations refer to the purchase and sale of US Treasury securities. I think of them as bonds. So when we talk about open market operations, the Fed is either buying these bonds or they're selling them. And we'll talk about when they would do either one of those things.

So we need to for a second take a look at how does the Fed get money into and out of circulation, because the Fed is the one who has the authority to print money in our country. Actually, they pay the Bureau of Engraving and Printing, part of the US Treasury, to print the money. But how does it then end up in our hands?

Do they just dump it out there? Who gets it? It's a confusing thing that a lot of people don't actually understand.

The process of actually getting that money that's been printed into and out of circulation actually happens through what we're talking about in this tutorial, the buying and selling of US Treasuries. And US Treasuries are bonds, bills, and notes.

So the idea is this. When the Fed wants to get the money that they've printed into M0, into that actual physical stock of cash in circulation, what they do is they buy Treasuries. They buy these US Treasuries.

I always think about it this way and talk to my students about it this way. Think about it like this. When someone buys something off of you, what do you end up walking away with after that transaction? You walk away with cash, right?

So when they're buying Treasuries, they pay cash to these bondholders to buy them off of them. And so therefore they're putting cash into circulation now, into people's hands. If the Fed wants to actually take money out of circulation, they just do the opposite. They sell securities.

So likewise, when someone sells something to you, what do you have to give up in a transaction? You have to give up cash, right? So buyers or these bondholders give up cash in exchange. And that takes money out of circulation. They then shred this cash, taking it out of M0.

All right. So how do they use this as a tool to manage our money supply? Well, the big idea is that the greater the supply of loanable funds, by loanable funds we mean money in the banks that the banks have available to loan out, the greater the ability they have to increase our money supply, so get money circulating in our economy.

So if the Fed wants to increase the amount of loanable funds and the amount of money in M0 out there in circulation, they buy bonds, because that puts money into people's hands. When they buy from us, basically, they're giving us cash. If the Fed wants to take money out of circulation and decrease or contract the money supply, they sell bonds. They take money out of circulation that way.

OK. So let's look at the impact this has on the money market. We have a demand and a supply for my name. The y-axis is the interest rate this time, because the interest rate is the price of money. And the quantity of money is on the x-axis.

We assume that the Fed controls the supply of money right now, so it's fixed. That's why it's a straight up and down line. But the demand for money does in fact vary with interest rates. Think about it this way up at high interest rates, where would you rather keep your money? Well, don't you want to keep it in the bank now, because interest rates are higher and you can earn more money on it? You can earn more interest on it.

At lower rates, you're like, eh, it's really not worth it to keep my money in my checking account or my savings account if it's earning 0.01%. So you take it out. And it's also now more attractive to take out a loan, because you can get a better interest rate. So that's why the demand for money varies with interest rates.

What happens with expansionary monetary policy, like with buying of bonds, when they're putting money into circulation, they're increasing the money supply, which is a shift here to the right. So when they buy Treasuries, they're putting money into bondholders' hands, increasing the amount of money in circulation. Look at the overall impact in the economy. It lowers rates.

Well, what kind of impact do lower rates have? That's what we just talked about. People in firms tend to take money out of banks and get it out there in circulation.

They take advantage of lower rates. I might buy a home right now. I might buy a car.

This is very different than fiscal policy. Keep that in mind, because you're not going to go out and buy more groceries or necessarily go on a little weekend vacation because interest rates fell. It's different kinds of purchases. But it does increase people's willingness to do these interest-sensitive things, like buying homes and cars. This has an expansionary effect on the economy.

The opposite would be selling bonds. This is known as a tight money policy. So if they're contracting the money supply, they would engage in selling US Treasury securities, because they're taking money from bondholders, decreasing the amount of money in circulation. That's a shift of the money supply to the left. And that raises interest rates in the economy.

We talked about how at higher rates people in firms tend to keep money in the banks. And we take out fewer loans for homes and cars. We wait until rates hopefully fall again. That has a contractionary effect. The more money is tied up in the banks, the less spending and circulating of money is going on outside of the banks.

So in this tutorial, we looked at how we can classify money according to how liquid it is, into M0, M1, and M2. We talked about how the FOMC is the organization, the part of the Fed who manages and makes decisions about interest rates and the supply of money. And finally, we really focused on these open market operations, the sale and the purchasing of US Treasuries and how that's a big tool that the Fed uses to control how much money is in circulation.

Thanks so much for listening. Have a great day.

Notes on "Open Market Operations"

Terms to Know

M0

The narrowest definition of money, includes only the stock of physical currency.

M1

Includes demand deposits (checking account balances) + M0 (stock of physical currency).

M2

Time deposits + M1 (demand deposits + stock of physical currency).

Open-market Operations

One of the mechanisms available to the Fed to regulate interest rates and the money supply; open market operation refer to the purchase and sale of U.S. Treasury securities.