Open Market Operations

Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Open Market Operations?

An Open Market Operation or OMO is merely an activity performed by the central bank to either give or take liquidity to a financial institution or a group of financial institutions. OMO aims to strengthen the liquidity status of the commercial banks and take surplus liquidity from them.

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It influences the suppy of money in the economy. The central bank purchases and sells the government securities like treasury bills or bonds in the open market to control the money supply, leading to inflation control, interest rate stability and economic growth. This is done depending on the changes in market conditions or economic objective of the country.

Key Takeaways

  1. Open Market Operations is a task by the central bank to provide or withdraw liquidity from a financial institution or a collection of financial institutions.
  2. There are two ways to execute open market operations: buying government bonds from a bank or selling government bonds to the bank. 
  3. Also, there are two types of open market operations: temporary open market operations and Permanent open market operations. 
  4. Open market operations target interest rates and money supply. For the nation’s economy to grow at a predictable and steady rate, the central bank works to keep inflation within a specified range.

How Does Open Market Operations Work?

Open market operations economics are the central bank’s monetary policyMonetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more tool to maintain inflation, interest rates, money supply, and liquidity in the economy. The central bank can buy or sell securities under such operations depending on the economic conditions. Permanent measures are generally taken to target inflation and interest rates for the short-term duration. In contrast, temporary measures are typically taken to check liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more in the system for the near-term duration. Whether the general public buys or sells securities impacts the general public and business houses as the loans may get costlier or cheaper, respectively.

This process is a very powerful and a useful tool which is very flexible in nature. It is a form of monetary policy that can be easily and quickly implemented and directly influence the interest rate and money supply. This helps in maintaining economic stability.   

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Open Market Operations Explained in Video

Steps

The central bank takes either of the following two main steps based on the economic conditions, which are known as Open Market Operations:

1. Buying government bonds from banks
2. Selling government bonds to banks

Let us discuss each step of open market operations economics in detail:

  1. Buying Government Bonds from Bank


    When the country’s central bank buys government bonds, the economy is usually in the recessionary gap phase, with big unemployment problems.

    When the central bank buys government bonds, it increases the money supply in the economy. The increased money supply decreases interest rates that cause consumption and investment spending to grow, and hence the aggregate demand rises. This, further, causes real GDP to increase.

    Thus, buying government bonds from banks increases the real GDP of the economy; hence this method is also called Expansionary Monetary policy.

  2. Selling Government Bonds to Banks


    The central banks sell government bonds to banks when the economy faces inflation. The central bank tries to control inflation by selling government bonds to banks.

    When the central bank sells government bonds, it sucks the excess money from the economy. This causes a decrease in the money supply, which causes interest rates to increase. An increased interest rate causes consumption and investment spending to fall, and thus aggregate demand falls. This causes real GDP to fall.
    Thus, selling government bonds to banks decreases the real GDP of the economy; hence this method is also called Contractionary Monetary policy.

Types

There are two types of open market operations:

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# 1 – Permanent Open Market Operations

The first type of open market operations macroeconomics is involved in the outright buying and selling of government securities. Such an operation is taken to have long-term benefits like inflation, unemployment, accommodating the trend of currency in circulation, etc.

#2 – Temporary Open Market Operations

This is usually done for the transitory the reserve requirementsThe Reserve RequirementsReserve Requirement is the minimum liquid cash amount in a proportion of its total deposit that is required to be kept either in the bank or deposited in the central bank, in such a way that the bank cannot access it for any business or economic activity.read more or to provide money for the short term. Such an operation is done using either repo or reverses reposReverses ReposA Reverse Repurchase Agreement is an agreement between a buyer and seller that states that the buyers of securities who purchased any type of securities or assets have the right to sell them at a higher price in the future, whereas the seller is required to accept the higher price in the future.read more. A repo is an agreement by which a trading desk buys a security from the central bank with a promise to sell it later. It can also be considered a short-term collateralized loan by the central bank with the difference in the purchase price and the selling price as the interest rate on the security. Under the reverse repo, the trading deskTrading DeskA trading desk is a section within a bank or company that buys and sells securities such as bonds, shares, currencies, and commodities to facilitate their own or clients' trades in the financial markets, ensuring market liquidity.read more sells the security to the central bank with an agreement to buy at a future date. Overnight ReposReposA repurchase agreement or repo is a short-term borrowing for individuals who deal in government securities. Such an agreement can happen between multiple parties into three types- specialized delivery, held-in-custody repo and third-party repo.read more and reverse repos are used for such temporary open market operations.

Examples

Let’s understand the Open Market Operations Examples with the help of one more example:

Advantages

Some advantages related to the economic process of open market operations macroeconomics are as follows:

#1 – Inflation and Interest Rate Targeting

  • The major target of these operations is interest rates and inflation. The central tries to maintain inflation at a certain range so that the country’s economy grows at a stable and steady pace. The central bank takes this as a close relation with interest rates. When the central bank open market operations offers securities and government bonds to other banks and the public, it also affects the supply and demand of credit.
  • The buyers of the bonds deposit the money from their account to the central bank’s account, thereby decreasing their reserves. Commercial banks buying such securities will have less money to lend to the general public, thus reducing their credit creation capacity. Thereby impacting the supply of credit.
  • When the central bank sells the securities, there is a decrease in the price of the bonds, and since bond prices and interest rates are inversely related, the interest rates rise. As the interest rates rise, there is a decrease in the demand for credit.
  • When the central bank sells the securities, there is a decrease in the price of the bonds, and since bond prices and interest rates are inversely related, the interest rates rise. As the interest rates rise, there is a decrease in the demand for credit.
  • When the central bank buys the securities, the cycle is reversed, inflation rises, and interest rates decrease.

#2 – Money Supply Targeting

The central bank open market operations may target and control the money supply in the economy. The central bank tries to maintain adequate liquidity in the banking system. When it feels there is high liquidity, it tries to suck the excess liquidity by selling bonds and vice-versa.

E.g., the Reserve Bank of India conducted two open market operations (OMO) purchase auctions of Rs 10,000 crores each on June 21, 2018, and July 19, 2018, to maintain durable liquidity.

This may be done to check the currency’s value for fiat currencies and other foreign currencies.

Limitations

Let us study the limitations of the process in details:

·      The impact of the policy is only for short term. The long term aspects like unemployment, economic growth, etc have limited effect.

·      The process is dependent on the financial market and its responsiveness. The policy will not have much impact if the market is illiquid or if the participants are not responsive enough.

·      It leads to distortion of asset prices to some extent. When the central banks purchase the economic assets, the prices go up creating financial bubbles and incorrect allocation of capital.

·      In case the interest rates are very low or the the banks have huge reserves, the policy may not work.

·      There is always a time lag between the implementation and actual impact in the economy due to the influence of various factors like consumer spending, investment, etc.

·      The process of buying and selling government secuities may sometimes lead to accumulation of huge debt, which the government may not be able to pay on time.

Thus, it is important to understand the advantages and limitations of the system so that the process can be successfully implemented.

Open Market Operations Vs Quantitative Easing

Both the above are tools used in monetary policy for controlling the money supply and influencing the economy. But there are some differences between them, as follows:

  • The man objective of the former is to influence or control the money supply, interest rates and regulate the economic condition, whereas the objective of the latter is to increase the money supply, lower interest rates and boost lending.
  • The former is meant for short term but the latter is meant for long term.
  • The former deals with government securities like treasury bills and bonds whereas the latter deals with corporate bons and mortgage backed securities also along with the government securities.
  • The impact of the former is small and limited unlike te latter in which the impact is large because it involves significant purchase of assets for an extended time period.
  • The former is used by the central bank quite frequently whereas the latter is used by the central bank in case of extraordinary economic conditions.

Thus, both of them influence the money supply and interest rates but their objective, type of asset and scale of operation is different.

Frequently Asked Questions (FAQs)

What are the advantages of Open market operations?

The primary benefit of open market activities is the direct infusion of funds into the economy (or they extract money directly from it). Therefore, the Fed wants to be able to affect the money supply when it conducts open market operations.

What are the other two types of OMOs?

Outright OMOs are irrevocable; when the central bank purchases assets to inject money into the economy, it does not commit to selling those assets afterward. Instead, in this transaction, when the central bank purchases the security, the date and selling price are laid forth in the purchase agreement.

How does open market operations affect the money supply?

The government uses open market operations to purchase or sell securities to banks. The Government provides banks with additional funds to maintain as reserves on their balance sheets when it purchases securities. When the Government sells securities, it depletes the money supply by removing funds from banks.

This has been a guide to what is Open Market Operations. We explain it with example, differences with quantitative easing, types, advantages & limitations. You may look at these articles below to learn more about Economics.