Open Market Operations

Open market operations, is the process of buying and selling of government securities with an aim of expanding the amount of money in the banking system. Purchasing of government securities helps to inject more money into the system and in the end; it helps to stimulate economic growth. Sell of securities on the other hand ejects money out of the system.

Open market operations are also some the most effective principle tools of monetary policy. This is based on the fact that the discount rate and reserve requirements are used in the operations. In the US, the Federal Reserve uses open market operations to adjust the rate of federal funds. This is the rate at which banks and financial institutions use to borrow reserves from each other.

The process of open market operations today

Money across many economies today basically exists in electronic records. Therefore, open market operations are conducted electronically. This is done by decreasing or increasing the amount of base cash in the banking system. The process does not require any new currency for it to be effective.

However, it increases the requirement by the central bank to print currency especially when a member bank is in need of banknotes. A commercial bank may need banknotes to decrease the amount it has in its electronic balance.

Additionally, the central bank acts to maintain short term interest rate in the event of increased demand for base money. The bank does this by increasing the supply of base cash. It goes to an open market to buy the amount of financial assets it needs in form of government bonds.

Bank reserves will pay for the assets in the form of base money and it will be transferred to the seller’s bank. The account of the seller is also credited. At the end of the day, base money in the economy will be increased. On the other hand, the central bank can decide to sell assets in the open market. In such a case, the amount of base cash in the buyer’s account is decreased thus, reducing base money.

Open market operations therefore works effectively because, the central bank has the power to bring enough money into and out of existence. The central bank is the only point in a financial system with unlimited powers to produce money. In other situations, another organization can influence open market but for a specific period of time only. Even so, the central bank will always have the over power to influence the supply of money.

Open market operations target

• Open market operations target short term interest rates in any debt market. This target is however changed periodically with an aim to achieve an inflation rate within a target and maintain it.
• Contraction of money supply is also a target for open market operations
• The policy can also be used to achieve and maintain a specific or fixed exchange rate in relation to a foreign currency
• Under gold standard, open market operations would be used to keep the value of flat currency as opposed to converting notes into gold
• The central bank can also use a mixture of open market operations policy settings under specific circumstances to achieve the desired monetary outcomes. Policies that can be used with open market operations include capital controls and changes in reserve requirements.

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Sources

http://www.federalreserve.gov/monetarypolicy/openmarket.htm

http://www.investopedia.com/terms/o/openmarketoperations.asp

http://en.wikipedia.org/wiki/Open_market_operation