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Open Market

The Fed implements monetary policy by directly influencing short term interest rates.  It does this through its control of the interbank lending rate, also known as the Fed funds rate.  This involves supplying just enough reserves to meet the demand at its target rate.  

The Objective 

The Fed supplies reserves to banks through its open market operations (OMO) and its discount window lending.  Discount lending now plays a minor role.  The principal tool is OMO in which the Fed buys or sells government securities in the secondary market to add or drain banking system reserves.  

Normally the objective of OMO is not to effect a net change in reserves; rather it is to counter variations in the total.  These variations are caused mainly by changes in the Treasury’s cash balances at the Fed, checking system float, foreign central bank transactions, and net cash flows in or out of banks.  However as net bank lending varies, the aggregate demand for reserves will vary and require the Fed to adjust the total in order to maintain control of the Fed funds rate. 

Basic Operations 

OMO is executed by the Trading Desk of the Federal Reserve Bank of New York, on behalf of the entire Federal Reserve System.  The Desk buys securities from government securities dealers who have an established trading relationship with the Fed.  It pays for the securities by sending funds to the dealer's account at its clearing bank, as it takes delivery of the securities at the Fed.  This action adds reserves to the banking system.  Conversely, when the Fed sells securities to a dealer, it delivers the securities and the account of the dealer is debited.  This action drains reserves from the banking system. 

Types of Transactions 

The Trading Desk most often engages in short-term repurchase agreements (RPs) which are used in situations that call for temporary additions to bank reserves.  With RPs, the Desk buys securities from the dealers, who agree to repurchase them at a specified date and at a specified price.  When the RPs mature, the added reserves are automatically drained. 

If there is a temporary need to drain reserves, the Trading Desk executes reverse RPs with dealers in Treasuries.  These transactions involve a contract for immediate sale of Treasury bills to the dealer, with a matching contract for later purchase from the dealer.