Just wondering if someone could clear up my confusion.
Confusion about how money supply is permanent:
When the central bank buys bonds from banks in order to increase the money supply it is easy to see how this creates money. It’s through the money multiplier. But if the central bank sometimes buys and sometimes sells securities, the money supply would never change. For money supply to be ever-increasing (as it must be as there is always inflation) the central bank must be always be buying more than it sells.
What is the relation between the interest rate that the central bank sets (the Fed funds rate I think) and the interest rate it targets through open market operations? Why does it need to do both? How accurate can it get using open market operations?
I think you may be confusing two different aspects of the American fractional-reserve banking system. One method that the Federal Reserve uses to increase the money supply is by buying securities, yes. But it can also temporarily decrease the money supply by selling securities, pulling money out of circulation. This is temporary because interest must be paid on these securities (assuming the Fed doesn’t default), so the money supply will most likely increase as a result in the long-run.
The money multiplier is a slightly more complicated issue. In essence, because a bank is only required to keep a certain percentage of its deposits on-hand at any time (hence the term “fractional-reserve” to distinguish from “full reserve”), the money supply will increase when deposits are made and loans are given out. Here’s a better explanation (http://www.investopedia.com/terms/m/multipliereffect.asp).
The Federal funds rate, which is the interest rate that banks must pay when they take on loans from the Fed, is simply a tool the Federal Reserve uses to achieve their targeted inflation rate. When the Federal funds rate is lowered it becomes cheaper for commercial banks to take on loans from the Fed, expanding the money supply and lowering the money interest rate(as opposed to the market rate of interest, which the money rate would be equal or close to absent government distortions) and increasing inflation. The Federal Reserve does not need to manipulate the funds rate in order to lower interest rates, as this can also be achieved by buying securities or lowering the reserve ratio. However, the Federal funds rate is typically considered to be among the most powerful monetary tools at the Fed’s disposal, so it often provokes more dramatic changes in the interest rate than other avenues of credit expansion.
The Federal Reserve typically shoots for an annual inflation rate close to 2% (this policy has a name which currently escapes me). When employment falls the Federal Reserve will target higher interest rates in accordence to the Philips curve, which states that there is a limited inverse relationship between inflation and unemployment. If one uses the older CPI methodology for calculating annual inflation, it currently stands at around 10%, so take from that what you will.