As chairman of the

Federal Reserve

, Alan Greenspan plays a key role in influencing the money supply. In this article we'll examine how open market operations are used by the Fed to implement monetary policy. We'll also delve into the profound effects these decisions have on our economy and the key reports that are monitored to determine if the Fed is meeting its intended goals.

The Federal Reserve actually has three tools at its disposal to carry out monetary policy -- open market operations, the discount rate and reserve requirements. Open market operations are by far the most widely used mechanism.

When the economy is growing too fast and the inflation rate is high, the Fed will sell government securities from its portfolio to the open market. This decreases bank reserves, which means the money supply decreases.

When there are fewer bank reserves, short-term interest rates increase, which means consumers and businesses have to pay the bank more in order to borrow. Less borrowing means less spending, which slows the economy and eventually can reduce price pressures.

On the other hand, if the economy is growing too slowly and the inflation rate is low, the Fed will buy government securities, such as Treasury bills and notes. This increases bank reserves, increasing the money supply and causing short-term interest rates to decrease. Reduced rates induce consumers and businesses to borrow.

Consumers will borrow money for items such as automobiles or home loans. Businesses borrow to build their inventories or finance a new factory. As a result, economic growth will accelerate.

The Federal Reserve also will leave rates unchanged if the economy is growing at a moderate pace with low inflation or if it feels the economy will slow down by itself. The Fed will even take a wait-and-see approach with regard to how fast or how slowly the economy is growing, along with the rate of inflation, before determining monetary policy.

The major goals of the Federal Reserve include moderate growth, low unemployment and low inflation. To determine how open market operations have been influencing these areas, the Fed monitors key related reports for feedback.

Economic growth is measured by a major quarterly report detailing the nation's

gross domestic product. The monthly

employment report, which includes the unemployment rate, is also watched closely by the Fed.

Finally, the

producer price index,

consumer price index, the

employment cost index and capacity utilization rates all are monitored to determine the current inflation outlook.

As these reports are released, policymakers develop a consensus as to whether the economy and the inflation rate are growing too fast, too slow or just right. They look for the evidence and then they take a vote on whether to raise or lower rates or leave them unchanged.

By Jeff Neal, a contributing writer and options strategist at

Optionetics.com.