Open Market Operation

Open market operation is a monetary policy tool used by central banks to increase or decrease money supply by buying and selling government bonds in the open market.

When a central bank (in US the Federal Reserve) is interested in providing stimulus to the economy by increasing the money supply, it purchases government bonds from commercial banks and the public. In consideration for the bonds, the central bank pays the bondholders who keep the money in banks thereby increasing the commercial banks' excess reserves. Higher excess reserves means commercial banks can lend more money leading to increase in money supply and decrease in interest rates.

When the central bank is interested in controlling inflation, it sells government bonds to commercial banks and the public. Banks and the public pay the central bank in return of the bonds and this reduces excess reserves which in turn reduces the banks' ability to lend money, thereby decreasing money supply and increasing interest rates.

The volume of central bank sale and purchase of government bonds depends on the target federal funds rate. The higher the change needed in federal funds rate, the bigger the sale or purchase. There are circumstance when sale and purchase of government bonds is not enough to move the economy to its target state. In such situations central banks engage in quantitative easy which involves sale and purchase of financial assets (in addition to government bonds).

In US, the Federal Reserve's Open Market Operations Committee sets target federal funds rate. Sale and purchase decisions are made depending on whether the target rate is higher or lower than the current rate.

Example

It is end of January 2008 and the federal funds rate is 3%. Marci DeVera and Mary Wujek are trainee economists assisting the Open Market Operations Committee of the Federal Reserve. Data suggests that US economy is heading into a recession. Marci DeVera suggests that federal funds rate should be significantly reduced, say by 150 basis points. Mary Wujek says that the Federal Reserve need to sell government securities to reach the target federal funds rate. Critique the statements.

Marci is correct because in order to get out of an impending recession, the Federal Reserve need to trigger increase in consumption and investment by reducing the cost of borrowing. A lower cost of borrowing can be achieved by setting a lower federal funds rate.

Mary is incorrect because in order to reduce the federal funds rate, the Federal Reserve has to increase the money available in the economy. A reduction in interest rate is achieved when money supply increases relative to its demand. An increase in money supply is achieved when government securities are purchased from commercial banks and the public.

Written by Obaidullah Jan