Sample Essay
Open market operations are one of the most powerful tools that the Fed possesses to control money supply in the main Market. The Fed buys government securities in the open market when it wants to add to the reserves of the banks. The buying of securities results in an increase of money supply in the market. The process works something like this, the Fed buys up the securities from the reserve bank, after this the bank has basically more funds which to lend to the market basically an increase in money supply. The interest rate is derived from the interactions in the money market which includes demand and supply of money.
An increase in money supply is likely to put a downward pressure on the interest rates. The demand for money is dependent on many factors including inflation, real GDP growth and interest rates. However it can be assumed that a decrease in interest rates will result in an increase in demand for money (MI and M2). Generally the Fed engages in buying of securities when it fears an economic slowdown. For example in recent economic history of recession the Fed has been engaged in buying of securities (eg promise to buy one trillion worth of securities on March 18 2009) in order to spur economic growth. Economic growth is spurred due to the downward pressure on interest rates which means it becomes cheaper to do business.
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