Open Market Operations (Examples) | How Open Market Operations works?

Economics Tutorials

What is Open Market Operations?

The open market operation is a monetary policy tool used by the central bank of the Country to either increase or decrease the money supply in the economy by sale or purchase of government securities.

Steps of Open Market Operations

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

Buying government bonds from banks
Selling government bonds to banks

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

#1 – Buying Government Bonds from Banks

When the central bank of the Country buys government bonds the economy is usually in the recessionary gap phase with unemployment being a big problem.

When the central bank buys government bonds it increases the money supply in the economy. The increased money supply decreases the interest rates. The decreased interest rates cause consumption and investment spending to increase and hence the aggregate demand rises. Increased aggregate demand 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 is facing inflation. The central bank tries to control inflation by selling government bonds to banks.

When government bonds are sold by the central bank, it sucks the excess money from the economy. This causes a decrease in the money supply. A decreased money supply causes interest rates to increase. An increased interest rate causes consumption and investment spending to fall and thus aggregate demand falls. The decrease in aggregate demand 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 of Open Market Operations

There are two types of open market operations:

Permanent Open market operations
Temporary Open market operations

# 1 – Permanent Open Market Operations

This is involved in 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 reserve requirements that are transitory in nature or to provide money for a short term. Such an operation is done using either repo or reverses repos. A repo is an agreement by which a trading desk buys a security from the central bank with a promise to sell it at a later date. It can also be considered as 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 a reverse repo, the trading desk sells the security to the central bank with an agreement to buy at a future date. Overnight repos and reverse repos are used for such temporary open market operations.

Open Market Operations Examples

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

The Federal Reserve Bank (Central Bank of United States) purchased $175 million MBS from banks that had been originated by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Between January 2009-August 2010, it also bought $1.25 trillion in MBS that had been guaranteed by Fannie, Freddie, and Ginnie Mae. Between March 2009-October 2009, it purchased $300 billion of longer-term Treasuries from member banks.
As the Fed’s short-term Treasury bills matured, it used the proceeds to buy long-term Treasury notes to keep interest rates down. It continued to buy MBS with the proceeds of MBS that matured.

Advantages and Economic Targets of Open Market Operations

#1 – Inflation and Interest Rate Targeting

The major target of this operations is interest rates and inflation. The central tries to maintain inflation at a certain range so that the economy of the country grows at a stable and steady pace. This is taken by the central bank has a close relation with interest rates. When the central bank offers securities and government bonds to other banks and the public it affects the supply and demand of credit as well.
The buyers of the bonds deposit the money from their account to the central bank’s account thereby decreasing their own reserves. With the commercial banks buying such securities they 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 demand of credit.
With the decrease in supply and demand of credit due to less reserves and high-interest rates, consumption reduces thus reducing inflation.
When the central bank buys the securities the cycle is reversed, inflation rises and interest rates decrease.

#2 – Money Supply Targeting

The central bank 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.
Eg. Reserve Bank of India conducted two Open market Operations (OMO) purchase auctions of Rs 10000 crores each on June 21, 2018 and July 19, 2018 to maintain durable liquidity.
This may be done to check the value of the currency with respect to fiat currencies and other foreign currencies.

Conclusion

Open market operations are the central bank’s monetary policy 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 while temporary measures are generally taken to check liquidity in the system for the near-term duration. Depending on whether the general public buys or sells securities impacts the general public and business houses as the loans may get costlier or cheaper respectively.

Open Market Operations