A question about open market operations and the fed funds rate?

My understanding of the open market operations is that Central Banks buy and sell "financial instruments" (gold, bond, currency etc.) to banks increasing and decreasing the amounts of money in their reserve accounts.

1.)My first question is how does this increase or decrease in reserve funds changes or effects the fed fund rate (that is how does an increase in funds = a lower rate). Does more funds to lend result in funds being lent at lower rates?

2.)Why don't banks simply trade these securities on the open market rather than with the fed (which effects the money supply ). Wouldn't this effect the interest rate in the same way?

3.)Am I completely wrong about how the system works if so please explain.

2 Answers

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  • OPM
    Lv 7
    1 decade ago
    Favorite Answer

    You are sort of confusing a number of different tools together.

    The Fed uses open market operations by acting as a customer of dealers, just as you would. The dealers keep mum about who their counterparty is.

    1) It does not increase or decrease required reserves, it increases or decreases free reserves, essentially the "cash and due from banks" account. Reserves do not bear interest so more non-interest bearing assets in the system results in banks trying to get rid of them via loans to customers.

    2)They are trading on the open market and not with the Fed. They are not aware of who the other party to the transaction is. Treasury securities are offered on the dealer market not in an auction market.

    3) You were close. The Fed has accounts at various firms, such as JP Morgan. They enter into a trade, which Morgan facilitates, against transactions by ordinary people, financial institutions and mutual funds and pensions. The money does not directly roll into their reserve accounts. The money goes from the Fed, to the dealers, and from the dealers to the buyers accounts, wherever they happen to be. It could be that the counter party is the Bank of Japan, by chance, in which case the money would roll into "special drawing rights," for the BoJ.

  • juli
    Lv 4
    5 years ago

    No impact of federal tax.

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