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 consists of the seven members of the Board of Governors plus five regional bank presidents. The president of the New York Federal Reserve Bank serves as a member of the FOMC; the other 11 bank presidents take turns filling the remaining four seats.
In practice, the Fed sets targets for the federal funds rate. To achieve a lower federal funds rate, the Fed goes into the open market buying securities and thus increasing the money supply. When the Fed raises its target rate for the federal funds rate, it sells securities and thus 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.