Operating Tools of the Federal Reserve Board
The Federal Reserve Board (the Fed) uses three tools to implement monetary policy:
- • Open market operations
- • Discount window lending
- • Altering the reserve requirements
In open market operations, the Federal Reserve buys and sells U.S. Treasuries and federal agency securities in the open market. This is the most common tool of the Fed. To grow the economy, the Fed will purchase government securities, to put more money into the money supply. The greater availability of money causes interest rates to go down because money is now more available and less costly to borrow. The lower interest rates lead consumers to borrow more and then spend more, growing the economy.
If the Fed would like to slow the economy, and this happens most often if inflation is rising too quickly, it will sell more Treasuries. When the Fed sells Treasuries, money is used to buy the Treasuries, which leads to a reduction in the money supply and an increase in the cost of credit. If borrowing is more expensive, Americans borrow less and spend less, slowing inflation and the broader economy.
Example: The Fed wants to stimulate the economy, so it purchases government securities. This puts more money into the market, which lowers interest rates.
Because interest rates decline, the prices of municipal bonds in the secondary market increase. This is because the interest payments of current bonds, which are now high relative to new bonds, are more appealing to investors.
Example: The Fed wants to slow down inflation, so it sells government securities. Investors purchase the securities, reducing the amount of money in the economy (the money supply). The reduced money supply raises interest rates.
Rising interest rates lower the prices of municipal bonds in the secondary market. This is because new municipal bonds are paying higher interest rates than secondary market bonds. So sellers will have to reduce the pric