Page 19

sold to recover cash) to quickly carry out transactions at any desired time with any desired volume. The enormous US government securities market provides the Fed with the best and the most accommodating means of conducting open market operations, and T-bills are the type of security most frequently used. For example, when the Monetary Policy calls for lower interest rates, the Fed purchases T-bills from the market and issues checks to the sellers. When the sellers deposit these payment checks in their accounts (which might be done automatically for them using electronic wire), their respective banks demand payment from the Fed. In turn the Fed makes its payments by increasing the banks' reserves. Finally, increased reserves result in a reduction in interest rates, beginning with the funds rate.

So what is the relationship between the government securities and interest rates? Simply put, many interest rates (e.g., mortgage rates, CDs, auto loans, etc.) are tightly based on government securities' yields. (What is yield? See the next section.) Those yields (such as bond yields) are usually the first things that are affected at the hint of the Fed's intention to modify its Monetary Policy.

Let's finish up the US government security types topic with a couple of points. Interest payments on Treasury notes and bonds are nostalgically referred to as coupon payments, since in the past the buyer of these instruments would be given a coupon book with each coupon representing a particular interest payment. Then every time the owner was to collect the interest payment, she would tear out the specific coupon and present it to her bank. Today this procedure is automated and handled electronically, but it is still referred to as coupon payment.

Interest payments on government securities are subject to federal tax but are exempt from state and local taxes. Many traders also engage in the buying and selling of these securities in the open market (i.e., …