Kenneth R. Szulczyk
interest rates to 4%. If the current interest rate equals 6%, subsequently, the Federal Reserve
keeps buying T-bills until the interest falls to 4%. Nevertheless, as the Fed continually buys T-
bills, both the banks' reserves and the money supply expand. The Fed has no control over the
money supply because it focused on the interest rates. Thus, the Fed can either affect short-term
interest rates or the money supply, but not both at the same time.
Federal Open Market Committee
The Fed formed the Federal Open Market Committee (FOMC) to implement monetary
policy by buying or selling assets like U.S. government securities. The FOMC meets eight times
per year and issues a general directive that states the objective for the monetary aggregates and
interest rates. Furthermore, the Federal Reserve Bank of New York is responsible in carrying
out the general directive. The Fed Bank of New York deals with about 40 dealers who specialize
in U.S. government securities (i.e. secondary market). The New York Fed and dealers are
connected electronically. When the Fed is ready to buy or sell government securities, the Fed
ask these dealers to bid. Then the Fed buys or sells to the dealers with the best offer. The Open
Market Trading Desk is the department within the New York Fed Bank that buys and sells the
government securities.
When the trading desk at the Fed conducts monetary action, the trading desk can use
dynamic or defensive transactions. A dynamic transaction is the Fed uses a transaction to meet
the monetary policy as specified in the general directive. A defensive transaction is the Fed uses
open-market operations to offset fluctuations in bank reserves. The Fed uses defensive
transactions more than dynamic transactions. For example, the banks’ reserves fall, as people
withdraw money from their bank accounts to buy presents at Christmas or when people pay their
taxes in April. Consequently, the money supply decreases around Christmas and April.
Furthermore, natural disasters and employees' strikes can delay the delivery of the mail. A mail
delay slows the Fed’s check clearing process. Thus, the float rises, expanding both banks'
reserves and money supply. Accordingly, the Fed uses defensive transaction to offset temporary
fluctuations in bank reserves to stabilize the money supply.
The Fed can use outright purchases and sales or use repurchase agreements. First, the Fed
uses outright purchases and sales, when it sells or buys a security, and the transaction is
permanent. Dealer who bought the security has no obligation in the future to sell the security to
the Fed or vice-versa. Second, the Fed uses the Federal Reserve repurchase agreement (REPO)
to buy securities from a dealer, and the dealer agrees to repurchase the securities for a specific
price and on a particular date in the future. This is similar to a bank repurchase agreement.
Usually, the dealer buys back the government security within 15 days. Consequently, the REPO
injects temporary reserves into the banking system. For example, people around Christmas time
withdraw enormous amounts of currency from the financial institutions because they buy
Christmas presents with cash. Accordingly, the Fed uses a REPO to inject reserves temporarily
in the banking system to offset the currency drain. After Christmas, the currency returns to the
financial institutions. Then the REPO expires, and the temporary reserves are removed from the
banking system, when the dealer repurchases the REPO.