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The Federal Open Market Committee and the Role of the Fed
The Fed sets targets for the federal funds rate and then conducts operations to maintain that rate. To achieve a lower federal funds rate, for example, the Fed goes into the open market to buy securities and thus increase the money supply.
The FOMC decides on a target federal funds rate by looking at monetary targets such as inflation, interest rates, or exchange rates.
One of the primary tools used by the Federal Reserve (the Fed) to conduct monetary policy is open market operations: the buying and selling of federal government bonds in order to influence the money supply and interest rate. These operations are the primary responsibility of the Federal Open Market Committee (FOMC). The FOMC is a twelve-person committee composed of the seven members of the Board of Governors, plus a rotating combination of five presidents of the Federal Reserve Regional Banks. The president of the New York regional bank is always a member of the FOMC; the other four seats are filled by four of the other eleven bank presidents.
When conducting monetary policy the Fed sets a target for the federal funds rate, which it attempts to achieve using open market operations. To lower the federal funds rate, for example, the Fed buys securities on the open market, increasing the money supply. In order to raise the federal funds rate, on the other hand, the Fed sells securities and thereby reduces the money supply.
Open Market Operations
As mentioned previously, the aim of open market operations is to manipulate the short term interest rate and the total money supply. This involves meeting the demand for money at the target interest rate by buying and selling government securities or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.
Imagine the Fed is targeting a federal funds rate of 3%. If there is an increased demand for money and the Fed takes no action, interest rates will rise. This may produce unintended contractionary effects in the economy. Instead, the FOMC responds to an increase in the demand for money by going to the open market to buy a financial asset, such as government bonds, foreign currency, or gold. To pay for these assets, the Fed transfers bank reserves to the seller's bank and the seller's account is credited. Since the bank now has more reserves than it had before, it can lend out more money and the money supply increases. Thus, the increase in demand for money is met with an increase in supply, and the interest rate remains unchanged.
Conversely, if the central bank sells its financial assets on the open market, reserves are transferred from the buyer's bank back to the Fed. This reduces the amount of money that a bank may loan out and the total money supply falls. The process works because the central bank has the authority to bring money in and out of existence. They are the only point in the whole system with the unlimited ability to produce money.
Source: Boundless. “The Federal Open Market Committee and the Role of the Fed.” Boundless Economics. Boundless, 26 May. 2016. Retrieved 30 Sep. 2016 from https://www.boundless.com/economics/textbooks/boundless-economics-textbook/the-monetary-system-27/introducing-the-federal-reserve-115/the-federal-open-market-committee-and-the-role-of-the-fed-452-12549/