An Open Market Operation is a process whereby a central bank buys or sells government bonds on the open maket.
What's The Aim Of An Open Market Operation?
Central banks often use open market operations to adjust two things: short-term interest rates, and the overall money supply. Different central banks can pursue these actions for different reasons, based on economic conditions in their country.
How Does An OMO Actually Work?
Most central banks have the legal authority over expansion/contraction of the money supply, and setting the interest rates on loans that banks can charge one another. To expand the supply of money, the central bank goes to the open market to buy securities; usually governmnet bonds, due to their low yield and high liquidity, using newly created money. The banking system receives new money and the central bank gets securities that can be redeemed for deposits at a given interest rate. To contract the money supply, the central bank sells securities back onto the open market. It is worth noting that, due to the advance of computers into the marketplace, the process of exchanging securities for money is often conducted electronically, as opposed to using actual paper money. Central banks often either credit or debit amounts from the accounts of their member banks without the creation of additional paper notes
Why Expand The Money Supply?
In times of economic growth or recovery, the demand for money increases as businesses expand, investment increases, and banks lend more. Because of this increase in demand, the money supply must be expanded to support the growth of the economy and provide a continual influx of new capital.
Expanding the money supply is also used to stimulate the economy in times of recession or depression as central banks add new lower interest rates (which makes it easy for one financial institution to borrow from another over short periods) or even directly purchase illiquid assets from banks and other institutions to inject capital directly into the banking system and maintain cash flow.