Open market operation
Encyclopedia
Open market operations is the buying and selling of government bonds on the open market by a central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

. It is the primary means of implementing monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

 by a central bank. The usual aim of open market operations is to control the short term interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

 and the supply of base money in an economy, and thus indirectly control the total money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

. This involves meeting the demand of base money at the target interest rate by buying and selling government securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...

, or other financial instruments. Monetary targets such as inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

, interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

s or exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

s are used to guide this implementation.

Process

Since most money is now in the form of electronic records rather than cash, open market operations are conducted simply by electronically increasing or decreasing ('crediting' or 'debiting') the amount of base money that a bank has in its reserve account at the central bank. Thus, the process does not literally require new currency. (However, this will increase the central bank's requirement to print currency when the member bank demands banknotes, in exchange for a decrease in its electronic balance.)

When there is an increased demand for base money, the central bank must act if it wishes to maintain the short-term interest rate. It does this by increasing the supply of base money. The central bank goes to the open market to buy a financial asset such as government bonds, foreign currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...

, gold
Gold
Gold is a chemical element with the symbol Au and an atomic number of 79. Gold is a dense, soft, shiny, malleable and ductile metal. Pure gold has a bright yellow color and luster traditionally considered attractive, which it maintains without oxidizing in air or water. Chemically, gold is a...

, or seemingly nonvolatile (until the 2008 financial fallout) MBS's  (Mortgage Backed Securities). To pay for these assets, bank reserves in the form of new base money (for example newly printed cash) are transferred to the seller's bank and the seller's account is credited. Thus, the total amount of base money in the economy is increased. Conversely, if the central bank sells these assets in the open market, the amount of base money held by the buyer's bank is decreased, effectively destroying base money.

Possible targets of open market operations

  • Under inflation targeting
    Inflation targeting
    Inflation targeting is an economic policy in which a central bank estimates and makes public a projected, or "target", inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools.Because interest rates and the...

    , open market operations target a specific short term interest rate in the debt markets. This target is changed periodically to achieve and maintain an inflation rate within a target range. However, other variants of monetary policy also often target interest rates: the US Federal Reserve, the Bank of England
    Bank of England
    The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world...

     and the European Central Bank
    European Central Bank
    The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...

     use variations on interest rate targets to guide open market operations.
  • Besides interest rate targeting there are other possible targets of open markets operations. A second possible target is the contraction of the money supply
    Money supply
    In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

    , as was the case in the U.S. in the late 1970s through the early 1980s under Fed Chairman Paul Volcker
    Paul Volcker
    Paul Adolph Volcker, Jr. is an American economist. He was the Chairman of the Federal Reserve under United States Presidents Jimmy Carter and Ronald Reagan from August 1979 to August 1987. He is widely credited with ending the high levels of inflation seen in the United States in the 1970s and...

    .
  • Under a currency board
    Currency board
    A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target....

     open market operations would be used to achieve and maintain a fixed exchange rate
    Fixed exchange rate
    A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.A fixed exchange rate is usually used to...

     with relation to some foreign currency.
  • Under a gold standard
    Gold standard
    The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard...

    , notes would be convertible to gold, so there would be no open market operations. However, open market operations could be used to keep the value of a fiat currency constant relative to gold.
  • A central bank can also use a mixture of policy settings that change depending on circumstances. A central bank may peg its exchange rate (like a currency board
    Currency board
    A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target....

    ) with different levels or forms of commitment. The looser the exchange rate peg, the more latitude the central bank has to target other variables (such as interest rates). It may instead target a basket of foreign currencies rather than a single currency. In some instances it is empowered to use additional means other than open market operations, such as changes in reserve requirements or capital controls, to achieve monetary outcomes.

USA

In the United States, as of 2006 the Fed sets an interest rate target for the Fed funds
Federal funds
In the United States, federal funds are overnight borrowings by banks to maintain their bank reserves at the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear financial transactions...

 (overnight bank reserves) market. When the actual Fed funds rate is higher than the target, the New York Reserve Bank will usually increase the money supply via a repo
Repurchase agreement
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...

 (effectively borrowing from the dealers' perspective; lending for the Reserve Bank). When the actual Fed funds rate is less than the target, the Bank will usually decrease the money supply via a reverse repo
Repurchase agreement
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...

 (effectively lending from the dealers' perspective; borrowing for the Reserve Bank).

In the U.S., the Federal Reserve (Fed) most commonly uses overnight repurchase agreement
Repurchase agreement
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...

s (repos) to temporarily create money, or reverse repos to temporarily destroy money, which offset temporary changes in the level of bank reserves. The Fed also makes outright purchases and sales of securities through the System Open Market Account (SOMA) with its manager over the Trading Desk at the New York Reserve Bank. The trade of securities in the SOMA changes the balance of bank reserves, which also affects short term interest rates. The SOMA manager is responsible for trades that result in a short term interest rate near the target rate set by the Federal Open Market Committee
Federal Open Market Committee
The Federal Open Market Committee , a committee within the Federal Reserve System, is charged under United States law with overseeing the nation's open market operations . It is the Federal Reserve committee that makes key decisions about interest rates and the growth of the United States money...

 (FOMC), or create money by the outright purchase of securities. Very rarely will it permanently destroy money by the outright sale of securities. These trades are made with a group of about 22 (currently 18 as an immediate aftermath of 08/09 credit crisis) banks or bond dealers who are called primary dealers
Primary dealers
Primary dealer is a formal designation of a firm as a market maker of government securities. Primary dealer systems are present in many countries including Canada, France, Italy, Spain, the United Kingdom, and the United States...

.

Money is created or destroyed by changing the reserve account of the bank with the Fed. The Fed has conducted open market operations in this manner since the 1920s, through the Open Market Desk at the Federal Reserve Bank of New York
Federal Reserve Bank of New York
The Federal Reserve Bank of New York is one of the 12 Federal Reserve Banks of the United States. It is located at 33 Liberty Street, New York, NY. It is responsible for the Second District of the Federal Reserve System, which encompasses New York state, the 12 northern counties of New Jersey,...

, under the direction of the Federal Open Market Committee
Federal Open Market Committee
The Federal Open Market Committee , a committee within the Federal Reserve System, is charged under United States law with overseeing the nation's open market operations . It is the Federal Reserve committee that makes key decisions about interest rates and the growth of the United States money...

.
The open market operation is also a means through which inflation can be controlled because when treasury bills are sold to commercial banks these banks can no longer give out loans to the public for the period and therefore money is being reduced from circulation.

Eurozone

The European Central Bank
European Central Bank
The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...

 has similar mechanisms for their operations; it describes its methods as a four-tiered approach with different goals: beside its main goal of steering and smoothing Eurozone
Eurozone
The eurozone , officially called the euro area, is an economic and monetary union of seventeen European Union member states that have adopted the euro as their common currency and sole legal tender...

 interest rates while managing the liquidity situation in the market the ECB also has the aim of signalling the stance of monetary policy with its operations.

Broadly speaking, the ECB controls liquidity in the banking system via Refinancing Operations, which are basically repurchase agreements, i.e. banks put up acceptable collateral with the ECB and receive a cash loan in return. These are the following main categories of refinancing operations that can be employed depending on the desired outcome:
  • The regular weekly main refinancing operations (MRO) with maturity of one week and,
  • the monthly longer-term refinancing operations (LTRO) provide liquidity to the financial sector, while ad-hoc
  • "fine-tuning operations" (in the form of reverse or outright transactions, foreign exchange swaps and the collection of fixed-term deposits) aim to smooth interest rates caused by liquidity fluctuations in the market and
  • "structural operations" are used to adjust the central banks' longer-term structural positions vis-a-vis the financial sector.


Refinancing operations are conducted via an auction mechanism. The ECB specifies the amount of liquidity it wishes to auction (called the allotted amount) and asks banks for expressions of interest. In a fixed rate tender the ECB also specifies the interest rate at which it is willing to lend money; alternatively, in a variable rate tender the interest rate is not specified and banks bid against each other (subject to a minimum bid rate specified by the ECB) to access the available liquidity.

MRO auctions are held on Mondays, with settlement (i.e. disbursal of the funds) occurring the following Wednesday. For example at its auction on 2008 October 6, the ECB made available 250 million in EUR on October 8 at a minimum rate of 4.25%. It received 271 million in bids, and the allotted amount (250) was awarded at an average weighted rate of 4.99%.

Since mid-October of 2008 however, the ECB has been following a different procedure on a temporary basis, the fixed rate MRO with full allottment. In this case the ECB specifies the rate but not the amount of credit made available, and banks can request as much as they wish (subject as always to being able to provide sufficient collateral). This procedure was made necessary by the financial crisis of 2008 and is expected to end at some time in the future.

Switzerland

The Swiss National Bank
Swiss National Bank
The Swiss National Bank is the central bank of Switzerland. It is responsible for Swiss monetary policy and for issuing Swiss franc banknotes.The names of the institution in the four official languages of the country are: ; ; ; ....

 currently targets the 3 month Swiss franc LIBOR rate. The primary way the SNB influences the 3 month Swiss franc LIBOR rate is through open market operations, with the most important monetary policy instrument being repo transactions.

India

India’s Open Market Operation is much influenced by the fact that it is a developing country and the capital flows are much different than other developed countries. Thus Reserve Bank Of India, being the Central Bank of the country, has to make policies and use instruments accordingly. Prior to the 1991 financial reforms, RBI’s major source of funding and control over credit and interest rates was the CRR (Cash reserve ratio) And the SLR (Statutory Liquidity Ratio
Statutory Liquidity Ratio
Statutory liquidity ratio is the amount of liquid assets, such as cash, precious metals or other approved securities, that a financial institution must maintain as reserves other than the cash with the Central Bank...

). But post the reforms, the use of CRR as an effective tool was de-emphasized and the use of Open market operations. OMO’s are more effective in adjusting market liquidity
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...

.

The two traditional type of OMO’s used by RBI:
  1. Outright Purchase (PEMO): Is outright buying or selling of government securities. (Permanent).
  2. REPO (Repurchase Agreement
    Repurchase agreement
    A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...

    ): Is short term, and are subject to repurchase.


But even after sidelining CRR as an instrument, there was still less liquidity and skewedness in the market. And thus on the recommendations of the Narshiman Committee Report(1998), The RBI brought together a Liquidity Adjustment Facility
Liquidity adjustment facility
Liquidity adjustment facility is a monetary policy tool which allows banks to borrow money through repurchase agreements....

 (LAF). It commenced in June, 2000 and it was set up to oversee liquidity on a daily basis and monitor market interest rates. For the LAF, two rates are set by the RBI: Repo rate and reverse repo rate. Repo rate is applicable while selling securities to RBI (Thus daily injection of cash flow(liquidity)), while reverse repo rate is applicable when banks buy back those securities(Absorption of liquidity). Also, these interest rates that are fixed by the RBI also help in determining other market interest rates.

India experiences large capital inflows every day, and even though the OMO and the LAF policies were able to withhold the inflows, another instrument was needed to keep the liquidity intact. Thus on the recommendations of the Working Group of RBI on instruments of Sterilization (December , 2003), a new scheme known as the Market stabilization scheme was set up. The LAF and the OMO’s were dealing with day to day liquidity management, whereas the MSS was set up to sterilize the liquidity absorption and make it more enduring.

Under this scheme the RBI issues additional T-bills and securities to absorb the liquidity . And the money goes into the Market Stabilization scheme Account(MSSA). And the RBI cannot use this account for paying any interest or discounts and cannot credit any premiums to this account. And the Government in collaboration with the RBI fixes a ceiling amount on the issue of these instruments.

But for an open market operation instrument to be effective , there has to be an active securities market for RBI to make any kind of effect on the liquidity and rates of interest.

See also

  • Debt monetization
  • Monetarism
    Monetarism
    Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...

  • Fractional Reserve Banking
  • Money creation
    Money creation
    In economics, money creation is the process by which the money supply of a country or a monetary region is increased due to some reason. There are two principal stages of money creation. First, the central bank introduces new money into the economy by purchasing financial assets or lending money...

  • Quantitative easing
    Quantitative easing
    Quantitative easing is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a pre-determined quantity of money into the economy...

  • Fiat currency
  • Credit money
    Credit money
    Credit money is any claim against a physical or legal person that can be used for the purchase of goods and services. Examples of credit money include personal IOUs, and in general any financial instrument or bank money market account certificate, which is not immediately repayable in specie, on...

  • Money supply
    Money supply
    In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

  • List of economics topics
  • List of finance topics

External links

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