HOME

TheInfoList



OR:

In
macroeconomics Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and ...
, an open market operation (OMO) is an activity by a
central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a centra ...
to give (or take) liquidity in its currency to (or from) a
bank A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital m ...
or a group of banks. The central bank can either buy or sell
government bonds A government bond or sovereign bond is a form of bond issued by a government to support public spending. It generally includes a commitment to pay periodic interest, called coupon payments'','' and to repay the face value on the maturity dat ...
(or other
financial asset A financial asset is a non-physical asset whose value is derived from a contractual claim, such as bank deposits, bonds, and participations in companies' share capital. Financial assets are usually more liquid than other tangible assets, such ...
s) in the
open market The term open market is used generally to refer to an economic situation close to free trade. In a more specific, technical sense, the term refers to interbank trade in securities. In economic theory Economists judge the "openness" of markets ...
(this is where the name was historically derived from) or, in what is now mostly the preferred solution, enter into a repo or secured lending transaction with a
commercial bank A commercial bank is a financial institution which accepts deposits from the public and gives loans for the purposes of consumption and investment to make profit. It can also refer to a bank, or a division of a large bank, which deals with ...
: the central bank gives the money as a deposit for a defined period and synchronously takes an eligible
asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that c ...
as
collateral Collateral may refer to: Business and finance * Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan * Marketing collateral, in marketing and sales Arts, entertainment, and media * ''Collate ...
. Central banks usually use OMO as the primary means of implementing
monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for federal funds, very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money s ...
. The usual aim of open market operations is—aside from supplying commercial banks with liquidity and sometimes taking surplus liquidity from commercial banks—to manipulate the short-term
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, t ...
and the supply of base money in an economy, and thus indirectly control the total
money supply In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circu ...
, in effect expanding money or contracting the money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government
securities A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
, or other
financial instrument Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form ...
s. Monetary targets, such as
inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduct ...
,
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, t ...
s, or
exchange rate In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of t ...
s, are used to guide this implementation. In the post-crisis economy, conventional short-term open market operations have been superseded by major central banks by
quantitative easing Quantitative easing (QE) is a monetary policy action whereby a central bank purchases predetermined amounts of government bonds or other financial assets in order to stimulate economic activity. Quantitative easing is a novel form of monetary pol ...
(QE) programmes. QE are technically similar open-market operations, but entail a pre-commitment of the central bank to conduct purchases to a predefined large volume and for a predefined period of time. Under QE, central banks typically purchase riskier and longer-term securities such as long maturity sovereign bonds and even corporate bonds.


Process of open market operations

The central bank maintains loro accounts for a group of commercial banks, the so-called direct payment banks. A balance on such a loro account (it is a nostro account in the view of the commercial bank) represents central bank money in the regarded currency. Since central bank money currently exists mainly in the form of electronic records (electronic money) rather than in the form of paper or coins (physical money), open market operations can be conducted by simply increasing or decreasing (''crediting'' or ''debiting'') the amount of electronic money that a bank has in its reserve account at the central bank. This does not require the creation of new physical currency, unless a direct payment bank demands to exchange a part of its electronic money against banknotes or coins. In most developed countries, central banks are not allowed to give loans without requiring suitable assets as collateral. Therefore, most central banks describe which assets are eligible for open market transactions. Technically, the central bank makes the loan and synchronously takes an equivalent amount of an eligible asset supplied by the borrowing commercial bank.


Theoretical relationship to interest rates

Classical economic theory postulates a distinctive relationship between the supply of central bank money and short-term interest rates: central bank money is like any other commodity in that a higher demand tends to increase its price (the interest rate). When there is an increased demand for base money, the central bank must act if it wishes to maintain the short-term interest rate. It does this by increasing the supply of base money: it goes to the open market to buy a financial asset, such as
government bonds A government bond or sovereign bond is a form of bond issued by a government to support public spending. It generally includes a commitment to pay periodic interest, called coupon payments'','' and to repay the face value on the maturity dat ...
. To pay for these assets, new central bank money is generated in the seller's loro account, increasing the total amount of base money in the economy. Conversely, if the central bank sells these assets in the open market, the base money is reduced. The process works because the central bank has the authority to bring money in and out of existence. It is the only point in the whole system with the unlimited ability to produce money. Another organization may be able to influence the open market for a period of time, but the central bank will always be able to overpower their influence with an infinite supply of money. Side note: Countries that have a free floating currency not pegged to any commodity or other currency have a similar capacity to produce an unlimited amount of net financial assets (bonds). Understandably, governments would like to utilize this capacity to meet other political ends like unemployment rate targeting, or relative size of various public services (military, education, health etc.), rather than any specific interest rate. Mostly, however the central bank is prevented by law or convention from giving way to such demands, being required to only generate central bank money in exchange for eligible assets (see above).


Possible targets

* Under
inflation targeting In macroeconomics, inflation targeting is a monetary policy where a central bank follows an explicit target for the inflation rate for the medium-term and announces this inflation target to the public. The assumption is that the best that moneta ...
, open market operations target a specific short-term interest rate in the debt markets. This target is changed periodically to achieve and maintain an inflation rate within a target range. However, other variants of monetary policy also often target interest rates: the
US Federal Reserve The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after ...
, the
Bank of England The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694 to act as the English Government's banker, and still one of the bankers for the Government o ...
and the
European Central Bank The European Central Bank (ECB) is the prime component of the monetary Eurosystem and the European System of Central Banks (ESCB) as well as one of seven institutions of the European Union. It is one of the world's most important centra ...
use variations on interest rate targets to guide open market operations. * Besides interest rate targeting there are other possible targets of open markets operations. A second possible target is the contraction of the
money supply In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circu ...
, as was the case in the U.S. in the late 1970s through the early 1980s under Fed Chairman
Paul Volcker Paul Adolph Volcker Jr. (September 5, 1927 – December 8, 2019) was an American economist who served as the 12th chairman of the Federal Reserve from 1979 to 1987. During his tenure as chairman, Volcker was widely credited with having ended th ...
. * Under a
currency board In public finance, a currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exch ...
open market operations would be used to achieve and maintain a
fixed exchange rate A fixed exchange rate, often called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another ...
with relation to some foreign currency. * Under a
gold standard A gold standard is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold. The gold standard was the basis for the international monetary system from the 1870s to the early 1920s, and from th ...
, notes would be convertible to gold, and so open market operations could be used to keep the value of a currency constant relative to gold. * A central bank can also use a mixture of policy settings that change depending on circumstances. A central bank may peg its exchange rate (like a
currency board In public finance, a currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exch ...
) with different levels or forms of commitment. The looser the exchange rate peg, the more latitude the central bank has to target other variables (such as interest rates). It may instead target a basket of foreign currencies rather than a single currency. In some instances it is empowered to use additional means other than open market operations, such as changes in reserve requirements or capital controls, to achieve monetary outcomes.


How open market operations are conducted


United States

In the
United States The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country Continental United States, primarily located in North America. It consists of 50 U.S. state, states, a Washington, D.C., ...
, , the
Federal Reserve The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
sets an interest rate target for the
federal funds In the United States, federal funds are overnight borrowings between banks and other entities to maintain their bank reserves at the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to cle ...
(''overnight bank reserves'') market. When the actual federal funds rate is higher than the target, the
Federal Reserve Bank of New York The Federal Reserve Bank of New York is one of the 12 Federal Reserve Banks of the United States. It is responsible for the Second District of the Federal Reserve System, which encompasses the State of New York, the 12 northern counties of Ne ...
will usually increase the money supply via a repurchase agreement (or repo), in which the Fed "lends" money to commercial banks. When the actual federal funds rate is less than the target, the Fed will usually decrease the money supply via a
reverse repo A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is a form of short-term borrowing, mainly in government securities. The dealer sells the underlying security to investors and, by agreement between the two par ...
, in which the banks purchase
securities A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
from the Fed. The
Federal Reserve The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
conducts open market operations with the objective of controlling short-term interest rates and the money supply. These operations fall into two categories: dynamic open market operations are intended to change the level of reserves and the monetary base, and defensive open market operations are intended to offset movements in other factors that affect reserves and the monetary base, such as changes in Treasury deposits with the Fed or changes in float. In the United States, the
Federal Reserve The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
most commonly uses overnight repurchase agreements (repos) to temporarily create money, or reverse repos to temporarily destroy money, which offset temporary changes in the level of bank reserves."Fedpoints: Repurchase and Reverse Repurchase Transactions"
Federal Reserve Bank of New York
The Federal Reserve also makes outright purchases and sales of securities through the System Open Market Account (SOMA) with its manager over the Trading Desk at the New York Reserve Bank. The trade of securities in the SOMA changes the balance of bank reserves, which also affects short-term interest rates. The SOMA manager is responsible for trades that result in a short-term interest rate near the target rate set by the
Federal Open Market Committee The Federal Open Market Committee (FOMC), a committee within the Federal Reserve System (the Fed), is charged under United States law with overseeing the nation's open market operations (e.g., the Fed's buying and selling of United States Treas ...
(''FOMC''), or create money by the outright purchase of securities."Fedpoints: Open Market Operation"
Federal Reserve Bank of New York.
More rarely will it permanently destroy money by the outright sale of securities. These trades are made with a group of about 22 banks and bond dealers called
primary dealers A primary dealer is a firm that buys government securities directly from a government, with the intention of reselling them to others, thus acting as a market maker of government securities. The government may regulate the behaviour and number of ...
. Money is created or destroyed by changing the reserve account of the bank with the Federal Reserve. The Federal Reserve has conducted open market operations in this manner since the 1920s, through the Open Market Desk at the
Federal Reserve Bank of New York The Federal Reserve Bank of New York is one of the 12 Federal Reserve Banks of the United States. It is responsible for the Second District of the Federal Reserve System, which encompasses the State of New York, the 12 northern counties of Ne ...
, under the direction of the
Federal Open Market Committee The Federal Open Market Committee (FOMC), a committee within the Federal Reserve System (the Fed), is charged under United States law with overseeing the nation's open market operations (e.g., the Fed's buying and selling of United States Treas ...
. OMOs also control inflation because when treasury bills are sold to commercial banks, it decreases the money supply.


Eurozone

The
European Central Bank The European Central Bank (ECB) is the prime component of the monetary Eurosystem and the European System of Central Banks (ESCB) as well as one of seven institutions of the European Union. It is one of the world's most important centra ...
has similar mechanisms for their operations; it describes its methods as a four-tiered approach with different goals: beside its main goal of steering and smoothing
Eurozone The euro area, commonly called eurozone (EZ), is a currency union of 19 member states of the European Union (EU) that have adopted the euro (€) as their primary currency and sole legal tender, and have thus fully implemented EMU pol ...
interest rates while managing the liquidity situation in the market the ECB also has the aim of signalling the stance of monetary policy with its operations. Broadly speaking, the ECB controls liquidity in the banking system via refinancing operations, which are basically repurchase agreements, i.e. banks put up acceptable collateral with the ECB and receive a cash loan in return. These are the following main categories of refinancing operations that can be employed depending on the desired outcome: * Regular weekly main refinancing operations (MRO) with maturity of one week and, * Monthly longer-term refinancing operations (LTRO) provide liquidity to the financial sector, while ''
ad hoc Ad hoc is a Latin phrase meaning literally 'to this'. In English, it typically signifies a solution for a specific purpose, problem, or task rather than a generalized solution adaptable to collateral instances. (Compare with ''a priori''.) Com ...
'' * "Fine-tuning operations" aim to smooth interest rates caused by liquidity fluctuations in the market through reverse or outright transactions,
foreign exchange swap In finance, a foreign exchange swap, forex swap, or FX swap is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward) and may use foreign exchange derivatives ...
s, and the collection of fixed-term deposits * "Structural operations" are used to adjust the central banks' longer-term structural positions vis-à-vis the financial sector. Refinancing operations are conducted via an auction mechanism. The ECB specifies the amount of liquidity it wishes to auction (called the allotted amount) and asks banks for expressions of interest. In a fixed rate tender the ECB also specifies the interest rate at which it is willing to lend money; alternatively, in a variable rate tender the interest rate is not specified and banks bid against each other (subject to a minimum bid rate specified by the ECB) to access the available liquidity. MRO auctions are held on Mondays, with settlement (i.e., disbursal of the funds) occurring the following Wednesday. For example, at its auction on 6 October 2008, the ECB made available 250 million in EUR on 8 October at a minimum rate of 4.25%. It received 271 million in bids, and the allotted amount (250) was awarded at an average weighted rate of 4.99%. Since mid-October 2008, however, the ECB has been following a different procedure on a temporary basis, the fixed rate MRO with "full allotment". In this case the ECB specifies the rate but not the amount of credit made available, and banks can request as much as they wish (subject as always to being able to provide sufficient collateral). This procedure was made necessary by the financial crisis of 2008 and is expected to end at some time in the future. Though the ECB's main refinancing operations (''MRO'') are from repo auctions with a (bi)weekly maturity and monthly maturation, Longer-Term Refinancing Operations (LTROs) are also issued, which traditionally mature after three months; since 2008, tenders are now offered for six months, 12 months and 36 months.


Switzerland

The Swiss National Bank (SNB) currently targets the three-month Swiss franc
LIBOR The London Inter-Bank Offered Rate is an interest-rate average calculated from estimates submitted by the leading banks in London. Each bank estimates what it would be charged were it to borrow from other banks. The resulting average rate is u ...
rate. The primary way the SNB influences the three-month Swiss franc LIBOR rate is through open market operations, with the most important monetary policy instrument being repo transactions.


India

India's Open Market Operation is much influenced by the fact that it is a developing country and that the capital flows are very different from those in developed countries. Thus India's central bank, the
Reserve Bank of India The Reserve Bank of India, chiefly known as RBI, is India's central bank and regulatory body responsible for regulation of the Indian banking system. It is under the ownership of Ministry of Finance, Government of India. It is responsible f ...
(RBI), has to make policies and use instruments accordingly. Prior to the 1991 financial reforms, RBI's major source of funding and control over credit and interest rates was the cash reserve ratio (CRR) and the SLR (
Statutory Liquidity Ratio In India, the Statutory liquidity ratio (SLR) is the Government term for the reserve requirement that commercial banks are required to maintain in the form of cash, gold reserves,Govt. bonds and other Reserve Bank of India (RBI)- approved securi ...
). But after the reforms, the use of CRR as an effective tool was deemphasized and the use of open market operations increased. OMOs are more effective in adjusting arket liquidity The two type of OMOs used by RBI: #
Outright purchase Outright was an accounting and bookkeeping application that assists small businesses and sole proprietors with managing their business's income and expenses. It also provided them with a means to organize and categorize expenses for filing a S ...
('): Is outright buying or selling of government securities. (Permanent). # Repurchase agreement ('): Is short term, and are subject to repurchase. However, even after sidelining CRR as an instrument, there was still less liquidity and skewedness in the market. And thus, on the recommendations of the Narsimham Committee Report (1998), the RBI brought together a Liquidity Adjustment Facility (LAF). It commenced in June, 2000, and it was set up to oversee liquidity on a daily basis and to monitor market interest rates. For the LAF, two rates are set by the RBI: repo rate and reverse repo rate. The repo rate is applicable while selling securities to RBI (daily injection of liquidity), while the reverse repo rate is applicable when banks buy back those securities (daily absorption of liquidity). Also, these interest rates fixed by the RBI also help in determining other market interest rates. India experiences large capital inflows every day, and even though the OMO and the LAF policies were able to withhold the inflows, another instrument was needed to keep the liquidity intact. Thus, on the recommendations of the Working Group of RBI on instruments of
sterilization Sterilization may refer to: * Sterilization (microbiology), killing or inactivation of micro-organisms * Soil steam sterilization, a farming technique that sterilizes soil with steam in open fields or greenhouses * Sterilization (medicine) rende ...
(December, 2003), a new scheme known as the market stabilization scheme (MSS) was set up. The LAF and the OMO's were dealing with day-to-day liquidity management, whereas the MSS was set up to sterilize the liquidity absorption and make it more enduring. According to this scheme, the RBI issues additional -bills and securities to absorb the liquidity. The money received goes into the Market Stabilization Scheme Account (''MSSA''). The RBI cannot use this account for paying any interest or discounts and cannot credit any premiums to this account. The government, in collaboration with the RBI, fixes a ceiling amount on the issue of these instruments.


See also

*
Fiat currency Fiat money (from la, fiat, "let it be done") is a type of currency that is not backed by any commodity such as gold or silver. It is typically designated by the issuing government to be legal tender. Throughout history, fiat money was some ...
*
Fractional Reserve Banking Fractional-reserve banking is the system of banking operating in almost all countries worldwide, under which banks that take deposits from the public are required to hold a proportion of their deposit liabilities in liquid assets as a reserv ...
*
Interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, t ...
*
List of economics topics The following outline is provided as an overview of and topical guide to economics: Economics – analyzes the production, distribution, and consumption of goods and services. It aims to explain how economies work and how economic agen ...
* List of finance topics *
Modern Monetary Theory Modern Monetary Theory or Modern Money Theory (MMT) is a heterodox * * * * * * macroeconomic theory that describes currency as a public monopoly and unemployment as evidence that a currency monopolist is overly restricting the supply ...
*
Monetarism Monetarism is a school of thought in monetary economics that emphasizes the role of governments in controlling the amount of money in circulation. Monetarist theory asserts that variations in the money supply have major influences on nati ...
*
Money creation Money creation, or money issuance, is the process by which the money supply of a country, or of an economic or monetary region,Such as the Eurozone or ECCAS is increased. In most modern economies, money creation is controlled by the central bank ...
*
Quantitative easing Quantitative easing (QE) is a monetary policy action whereby a central bank purchases predetermined amounts of government bonds or other financial assets in order to stimulate economic activity. Quantitative easing is a novel form of monetary pol ...


References


External links


Understanding Open market operation by M. A. Akhtar






{{Authority control Operations of central banks Monetary policy Monetary reform