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A lesson on open market operations and how the federal reserve increases and decreases the money supply in order to move interest rates and what this means for traders of the stock, futures, and foreign exchange markets.
In our last lesson we looked at the structure of the Federal Reserve and the components of the FOMC, the portion responsible for implementing Monetary Policy. Now that we have an understanding of this, we can look further into exactly how monetary policy is facilitated and what happens to markets under differing scenarios.
Monetary Policy very simply is anything which relates to action by the Federal Reserve to influence the amount of money and credit available in the economy. To understand exactly what this means, one first must understand the concept of fiat monetary systems.
Fiat Monetary Systems: The United States, like most major economies, has what is known as a fiat monetary system. A Fiat Monetary system very simply is any system which uses a monetary unit (in this case the US Dollar) which is not convertible to some commodity, in general a precious metal such as gold.
Fiat money, is money that is backed by the credit of some entity, normally a government, and the value for which is derived from its relative scarcity and the faith placed in it by the population which uses it.
This is important to us as traders because the fact that the Dollar is not convertible to a commodity such as gold gives the Federal Reserve the ability to increase or decrease the money supply as it sees fit, or in other words to enact Monetary Policy.
With this in mind the 3 tools available to the Fed for enacting monetary policy are:
• Open Market Operations
• The Discount Rate
• Reserve Requirements
The most common tool that the Fed uses, and therefore the one that we will cover, is Open Market Operations. Once we have an understanding of this and how increases or decreases in the supply of money affect demand and prices, the other two less commonly used tools will be more easily understood.
Through something which is known as the Open Market Committee, the Fed increases and decreases the supply of money by buying and selling US Government securities.
When The Fed wishes to reduce interest rates they will increase the supply of money by buying government securities using money that was not available in circulation before they made their purchase. As with anything, when additional supply is added and everything else remains constant, price normally falls. In this case the price that we are referring to is the cost of borrowing money or interest rates.
Conversely, when the fed wishes to increase interest rates they will instruct the open market committee to sell government securities thereby taking the money they earn on the proceeds of those sales out of circulation and reducing the money supply.