The Federal Open Market Committee, FOMC, is the Fed’s most important policymaking body. It is comprised of all 7 members of the Board of Governors along with the presidents of the Regional Federal Reserve Banks. All 12 presidents participate fully in each FOMC meeting, communicating information and views about the economy to the decision making process, although only 5 presidents vote. The president of the New York Fed, which handles the open market securities transactions on behalf of the System, serves as a permanent voting member, while the other presidents rotate annually.

The Federal Reserve is a vital participant in the money market primarily because the Federal Reserve controls the supply of reserves available to banks and other depository institutions through the FOMC’s actions. Like the other workings within the Fed, the Fed’s open market operation affects the supply of money through the reserves of depository institutions. It does so by adding or draining reserves through its open market operations.

The supply of reserves changes whenever base level of money enters or leaves the banking system. The demand for reserves will change whenever total demand deposits change, which occurs when banks increase or decrease aggregate lending. Changes in the supply of money can happen when the Fed, through the FOMC, buys or sells securities or when the public deposits or withdraws cash from banks.

open market operations are purchases and sales of U.S. Treasury and federal agency securities by the Fed. This tool is considered the Federal Reserve’s principal tool for implementing monetary policy. As with the other tools, the Fed’s open market operations affect the supply of money through the reserves of depository institutions.

The Fed controls the supply of reserves by buying and selling securities from banks through the Federal Open Market Operations at the New York Fed. By controlling the supply of reserves, the Federal Reserve is able to influence the federal funds rate.

The Federal Reserve’s objective for open market operations has varied over the years. During the 1980s, the focus gradually shifted toward attaining a specified level of the federal funds rate.

When the Fed wants to increase the flow of money and credit, it buys government securities; when it wants to restrict the flow of money and credit, it sells government securities.

Suppose the Fed wants the funds rate to fall. To do this, it buys government securities from a bank. The Federal Reserve would pay for the securities by adding money to that bank. The Fed has effectively paid for the securities by increasing that bank’s reserves. As a result, the bank now has more reserves than it wants. So the bank can lend these unwanted reserves to another bank in the federal funds market. Thus, the Fed’s open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls.

When the Fed wants the funds rate to rise, it does the reverse, that is, it sells government securities. This in effect supplies more short-term securities through the open market operations. The Fed receives payment in reserves from banks, which lowers the supply of reserves in the banking system. The increase in the supply of short-term securities restricts the money in circulation since borrowers give money to the Fed. In turn, this decrease in the money supply increases the short-term interest rate because there is less money in circulation for available for borrowers and the funds rate rises.

The Fed thus controls the Fed funds rate by adjusting the supply of reserves to meet the demand at its target interest rate. The Fed funds rate will then effectively set the upper limit on the cost of reserves to banks, and determines the interest rates that banks must charge the public for loans in order to turn a profit. Bank interest rates influence the demand for loans, and thereby the net amount of bank lending. That in turn determines the liquidity of the private sector, which is important in terms of aggregate demand and inflationary pressures. The selection and control of the Fed funds rate is the key monetary policy instrument of the Fed.

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