Open Market Operations

What Is Open Market Operation?

Open market operation is the purchase and sale of government securities, first class bills of exchange and promissory notes by the Reserve or Central Bank to control the volume of credit in the country.

When securities are purchased by central bank, then money supply with commercial banks and public increases. This will further expand credit in the economy. When securities are sold by central bank, then money supply in the economy decreases. This leads to credit contraction.

In other words, when the central bank decides to pump money into circulation, it buys back the government securities, bills and bonds, and when it decides to reduce money in circulation, it sells the government bonds and securities.

Open market operation has become the major instrument of monetary control Opens in new window; it is the most powerful and widely used tool of monetary control. First used in the US by the Federal Reserve System in 1922 has ever since been used as a major weapon of credit control in most developed countries. In those countries the evolution of well-developed, active interbank, money, and securities markets have enabled central banks to undertake outright or repurchase agreements in securities or foreign exchange as needed to provide or absorb bank reserves.

Advantages of Open Market Operations

The advantages of open market operations are well known.
  • The instrument provides great flexibility in the timing and volume of monetary policy operations at the initiative of the central bank.
  • It permits an impersonal, market-oriented business relationship with counterparties; and
  • Avoids the economic and market inefficiencies of direct controls.
The Ultimate Managed Hosting Platform

Open Market Operations in Relation to Other Monetary Instruments

If open market operations are to be the principal instrument of policy implementation, other monetary instruments obviously need to be adjusted supportively so as to ensure that day-to-day operating objectives are attainable and that the chances of reaching intermediate-term monetary guides, such as the money supply, are maximized.

The need for adjustment applies particularly to the discount window, or another central bank lending facility where the banking system can obtain reserves at its own initiative.

There are also reserve requirement issues.

The structure of requirements affects not only the predictability of the multiplier relationship between bank reserves and the money supply, but also banks’ speed of response to open market operations. The complementary adjustments in other monetary instruments that are most effective depend in part on the strategy adopted for conducting day-to-day open market operations.

In general, they can be conducted in one of two ways.
  • First, they can be actively aimed at a given quantity of reserves, letting the price of reserves (a monetary market or interbank interest rate) fluctuate freely along with fluctuations in the pressure on banks’ liquidity.
  • Second, they can be aimed at a particular market interest rate, letting the amount of reserves provided at the central bank’s own initiative be determined passively as a function of demand at that price.

Given the inherent volatility of money demand and a desire to avoid policies that risk destabilizing markets, central banks often follow a passive approach to open market operations, providing whatever reserves are needed to accommodate the demand for bank deposits and required reserves that actually emerges during a particular operating period (anywhere from a week to a month depending on the span of time over which banks must meet their reserve or clearing balance requirements).

If the monetary authorities were not following such an approach, the banking system, in a period when money demands were perhaps temporarily strong, would have to draw down excess reserves, increase borrowings at the central bank’s discount window, or undertake portfolio adjustments, with consequent upward pressure on money market interest rates as banks’ liquidity positions came under pressure.

The Ultimate Managed Hosting Platform

While accommodative in the short run, use of a passive approach to open market operations is nonetheless consistent with a monetary policy that stresses either interest rates or monetary and credit aggregates as intermediate objectives.

With the money supply as an objective, the central bank would ordinarily focus on control over a three- to six-month, or possibly longer, period and would accommodate to the week-to-week or month-to-month variations that are generally economically insignificant. However, control over the longer-term policy period would depend on the central bank’s ability to estimate the rather uncertain and indirect relationship between a money market rate or bank liquidity conditions and the responses of the banks and the public that influence the money supply.

It is unclear whether an active approach to open market policy that takes a particular reserve level — derived from, say, some longer-run path of desired money growth—as a direct target in an operating period would achieve more adequate control of money supply measures.

It would depend in part on the predictability of the multiplier relationship between reserve aggregates and the money supply. That relationship too may be variable and unstable, especially when financial markets are expanding and modernizing. Moreover, a rapidly changing financial structure would also tend to alter the economic significance of particular measures of money supply themselves.

Industrial countries have normally followed a more passive approach to providing reserves through open market operations.

A notable exception to such an approach was the policy followed by the U.S. Federal Reserve System from late 1979 to late 1982. At that time, the Federal Reserve chose a particular volume of nonborrowed reserves (the reserves provided through open market operations) as its short-term operating objective, with the amount determined by the presumed multiplier relationship to the policy’s money supply objective and an initial assumption about the amount of borrowed reserves.

The procedure was adopted in inflationary circumstances on the thought, first, that it would result in more assured money supply control. Second, after a while, as the policy approach was successfully sustained, it was expected to restore the Federal Reserve’s lost anti-inflation credibility. The highly developed U.S. markets were considered to be resilient enough to absorb the more volatile interest rate movements that were likely to, and did, occur.

The policy was abandoned after inflation was reduced and as it became apparent that changes in financial technology and institutional structure were making the relationship between various measures of money and overall economic and financial conditions increasingly uncertain. Reserves provided through open market operations were then once again determined passively, guided in effect by money market interest rate pressures.

In countries with markets at earlier stages of development, the absence of adequate secondary or interbank markets to provide signals about reserve needs and to convey the results of policy would be one reason for taking an active approach to reserve provision.

Another reason would be to clarify and better define the central bank’s policy objectives, especially when control of an existing inflationary episode is the overriding goal. Such an active approach is in effect embodied in a number of IMF supported programs for particular countries where control of inflation may be the predominant concern or where competitive markets may be at an early stage of development.

For particular policy reasons, though — for example, the importance to the country of exchange rate and balance of payments stability — such programs may use the net domestic assets of the central bank as a guideline rather than a bank reserve or monetary base aggregate.

In the end, whether a central bank uses a more passive or more active approach to open market operations will depend on the structure of its markets and economy, on the stability and predictability of the relationship between money supply measures and national economic objectives, and on the economic or financial issues that are of most concern to policy at the time.

The Ultimate Managed Hosting Platform