- Open market operations
Sales or purchases of government debt instruments (treasury bonds, treasury bills, treasury notes) on the open financial markets by a country's central bank (in the U.S., the Federal Reserve) as part of its efforts to influence the size of the money supply and the levels of interest rates. Central bank decisions to buy up government debt instruments make for an expansionary monetary policy, while sales of government debt instruments by the central bank represent a contractionary monetary policy.
When the Fed enters the financial markets and buys U.S. government securities, it pays for them by checks drawn on the Federal Reserve Bank's own account with itself, which the sellers of the securities then deposit in their own private bank accounts. The private banks in turn deposit the Fed's checks in their own accounts at the Fed — which means that the private banks now have extra reserves on which they can extend additional loans to their customers, thus tending to expand the size of the money stock and (in the short run, at least) to lower interest rates. (For example, if the reserve requirement is 20%, banks can legally create five times the amount of these new reserves by simply crediting the checking accounts of new borrowers.)
Conversely, when the Fed enters the financial markets and sells government securities it owns, the buyers pay for them with checks drawn on their accounts at their own banks and the Fed presents the checks for collection. When these checks clear and the private banks pay over the funds to the Fed, the private banks' deposits at the regional Federal Reserve banks decline by the amounts of these checks, reducing the private banks' reserves and thus reducing the amount of the loans that the banks may legally have outstanding. This tends to decrease the size of the money stock and (in the short term, at least) to raise interest rates. For example, if the reserve requirement is 20% and a particular bank is operating right at the legal minimum of reserves, it will have to reduce quickly the amount of the loans outstanding to its customers by five times the amount of the reduction in the bank's reserves in order to maintain the legally required reserve percentage.