An open market operation (OMO) is an activity by a central bank to give (or take) liquidity in its currency to (or from) a bank or a group of banks. The central bank can either buy or sell government bonds in the open market (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: the central bank gives the money as a deposit for a defined period and synchronously takes an eligible asset as collateral.

Central banks usually use OMO as the primary means of implementing monetary policy. 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 and the supply of base money in an economy, and thus indirectly control the total money supply, 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, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.[1][2]

In the post-crisis economy, conventional short-term Open Market Operations have been superseded by major central banks by quantitative easing (QE) programmes. QE are technically similar open-market operations, but entail a pre-commitment of the central bank to conduct purchases to a pre-define large volume and for a pre-define period of time. Under QE, central banks typically purchase riskier and longer-term securities such as long maturity sovereign bonds and even corporate bonds.

Mechanics of open market operations: Demand-Supply model for reserves market

Classical economic theory postulates a distinctive relationship between the supply of central bank money and short-term interest rates: like for a commodity, a higher demand for central bank money would 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. 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.

Technically, 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.[3]

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

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