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.
Why Contract The Money Supply?
Contracting the money supply usually happens when the amount of money in circulation is too high in relation to demand. In this case, central banks contract the money supply by selling securities to remove excess cash from bank reserves, or by literally destroying currency (this tends to happen when bills need to be removed from issue).
This is also useful to normalize interest rates after a period of extraordinarily low rates. During more strenuous economic periods, low interest rates help financial institutions have access to cheap sources of credit to cotinue operating, but to keep rates at zero or near-zero levels is dangerous over the long term, as such policies enable overleveraging and excessive risk taking.
Anything Else We Should Know?
For most central banks, open market operations are transactions that happen over the short-term, usually overnight, after the close of public stock exchanges. As discussed before, one of the primary motivations for modulating the money supply is to influence short term interest rates, which are used by a nation’s banks for the loans they charge each other on what’s known as the Interbank Lending Market. These loans are pledged for and issued overnight, and usually signal votes of market confidence in a given financial institution, whose financial position is reviewed by peers before being loaned more capital. Interbank lending has become a critical component of modern financial and banking systems, as banks borrow and exchange securities between themselves to finance new investments or their day-to-day operations. However, the 2008 housing derivative crisis exposed the weaknesses of this system, as a loss in confidence between banks could arrest the flow of capital through the economy. As such, central banks have used open market operations, to act as lenders of last resort for their banks, supplying liquidity when banks can’t access it from each other.