Monetary Policy
The Federal Reserve Board (the Fed) uses three tools to implement monetary policy: open market operations, discount window lending, and 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 go down, the price of municipal bonds in the secondary market goes up. This is because municipal bond interest payments, which are now high relative to current interest rates, are more appealing to investors.
Example: The Fed wants to slow down inflation, so it sells government securities. This reduces the amount of money in the economy, which boosts interest rates.
Rising interest rates lower the price of bonds in the secondary market. This is because bond prices have to be discounted to provide higher rates of return.
How does the Fed implement its open market operations? U.S. Treasuries are issued through a Dutch auction process in which bids are accepted from the highest bid on down, until all the