4.4 Monetary Policy Functions and Instruments
91
might ask, “Where does the Fed get securities to sell?” A brief look at the Fed’s balance sheet
will help provide an answer.
The Fed’s assets are primarily held in the form of U.S. Treasury, government agency, and
mortgage-backed
securities, which generally represent over 85 percent of total assets.
Coins
and cash in the process of collection are about 2 percent of total assets. The remainder is assets
that include gold certifi cates and Fed premises. Federal Reserve notes (recall our discussion of
fi at money in Chapter 2) represent nearly 90 percent of the Fed’s total liabilities and capital.
Deposits in the form of depository institution reserves held at the Reserve Banks are about
7 percent of the total. Other liabilities, particularly U.S. Treasury deposits and capital in the
form of stock purchased by member banks and surplus earned from operations,
make up the
remaining total liabilities and capital.
The original Federal Reserve Act did not provide for open-market operations. However,
to maintain stability in the money supply, this policy instrument developed out of Reserve
Bank experiences during the early years of Fed operations. Unfortunately, these early eff orts
were not well coordinated. Reserve Banks bought government securities with funds at their
disposal to earn money for meeting expenses and to make a profi t and pay dividends on the
stock held by member banks. All 12 Reserve Banks usually bought and sold the securities
in the New York market.
At times, their combined sales were so large that they upset the
market. Furthermore, the funds used to buy the bonds ended up in New York member banks
and enabled them to reduce their borrowing at the Reserve Bank of New York. This made it
diffi
cult for the Reserve Bank of New York to maintain eff ective credit control in its area. As a
result, an open-market committee was set up to coordinate buying and selling of government
bonds. The Federal Open Market Committee was legally established in 1933. In 1935 its
present composition was established: the Federal Reserve BOG plus fi ve of the presidents of
the 12
Reserve Banks, who serve on a rotating basis.
Open-market operations have become the most important and eff ective means of mon-
etary and credit control. These operations can take funds out of the market and, thus, raise
short-term interest rates and help restrain infl ationary pressures, or they can provide for easy
money conditions and lowered short-term interest rates. Of course,
such monetary ease will
not necessarily start business on the recovery road after a recession. When used with discount
rate policy, open-market operations are basically an eff ective way of restricting credit or mak-
ing it more easily available.
Open-market operations diff er from discount operations in that they increase or decrease
bank reserves at the initiative of the Fed, not of individual banking institutions. The process,
in simplifi ed form, works as follows. If the Federal Open Market Committee wants to buy
government securities, it contacts dealers to ask for off ers and then accepts the best off ers that
meet its needs. The dealers receive wire transfers of credit for the securities from the Reserve
Banks. These credits are deposited with member banks. The member banks, in turn, receive
credit for these deposits with their Reserve Banks, thus adding new bank reserves that form
the basis for additional credit expansion. The Fed usually restricts its purchases to U.S. govern-
ment securities primarily because of their liquidity and safety.
If the Fed
wants to reduce bank reserves, it sells government securities to the dealers.
The dealers pay for them by a wire transfer from a depository to a Reserve Bank. The Reserve
Bank then deducts the amount from the reserves of the depository institution.
Open-market operations do not always lead to an immediate change in the volume of
deposits. This is especially true when bonds are sold to restrict deposit growth. As bonds
are sold by the Reserve Banks, some banks lose reserves and are forced to borrow from their
Reserve Bank. Since they are under pressure from the Fed to repay the loans,
they use funds
from maturing loans to repay the Reserve Bank. Thus, credit can be gradually restricted as a
result of the adjustments banks must make to open-market operations.
Quantitative Easing
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