Dynamic Macroeconomics

20.4.1 Financial Markets and Open Market Operations
Monetary policy affects the economy through its effects on conditions in
financial markets, mainly nominal and real interest rates. In particular,
conventional monetary policy operates through interventions in money
markets, where short-term debt instruments (such as treasury bills and short-
term deposits of financial institutions) are traded. Through buying and selling
short-term securities, a central bank can affect short-term interest rates in the
market. If it wishes to increase short-term interest rates, then it sells treasury
bills or other short-term financial instruments, depressing their prices and
causing an increase in their interest yield. If it wishes to reduce short-term
interest rates, then it buys short-term financial instruments, causing their price
to increase and thus reducing their interest yield.
Consider a one-period discount bond that pays 
B
at the end of period 
t
. Its
price (value) at the beginning of the period is equal to 
V
= 
B/
(1 + 
i
), where 
i
is the nominal interest rate.
Arbitrage in financial markets thus ensures that the rate of return of a one-
period bond will be equal to the short-term interest rate 
i
. Hence, a (risk-
neutral) investor who could borrow at the short-term interest rate 
i
would be
indifferent between (1) borrowing at the interest rate 
i
and investing in the
bond or (2) not borrowing and not investing in the bond. It is clear that for a
given bond payment at the end of the period, there is an inverse relation

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between the bond price and the nominal interest rate. Thus, if the central bank
buys more short-term securities in the secondary market and increases their
price 
V
, it effectively reduces short-term interest rates. Such operations are
called 
open market operations
.
For example, the US Federal Reserve aims to affect the so-called federal
funds rate, which is an overnight rate. This is the interest rate at which
depository institutions, such as commercial banks, trade federal funds
(balances held at Federal Reserve Banks) with one another overnight. When
a depository institution has surplus balances in its reserve account, it lends to
other banks in need of larger balances. In other words, a bank with excess
liquidity will lend to another bank that needs to quickly raise liquidity. The
rate that the borrowing institution pays to the lending institution is determined
by the two banks; the weighted average rate for all of these types of
negotiations is called the 
effective federal funds rate
. The effective federal
funds rate is essentially determined by the market but is influenced by the
Federal Reserve through open market operations to reach the federal funds
rate target.
The Federal Open Market Committee meets eight times a year to
determine the federal funds target rate. This target rate influences the
effective federal funds rate through open market operations. More
specifically, the Federal Reserve decreases liquidity by selling treasury
bills, thereby raising the federal funds rate, because banks then have less
liquidity to trade with other banks. Similarly, the Federal Reserve can
increase liquidity by buying treasury bills, decreasing the federal funds rate,
because banks then have excess liquidity for interbank trades.
Similar procedures are followed by central banks in the other industrial
economies with developed financial markets, such as the European Central
Bank, the Bank of Japan, and the Bank of England.