Open market operation

From Free net encyclopedia

Open market operations are the means of implementing monetary policy by which a central bank controls its national money supply by buying and selling government securities, or other intruments. Monetary targets, such as interest rates or inflation, are used to guide this implementation.

Since most money is now in the form of electronic records, rather than paper records such as banknotes, open market operations are conducted simply by electronically increasing or decreasing the amount of money that a bank has, e.g. in its reserve account at the central bank, in exchange for the bank selling or buying a financial instrument. Newly created money is used by the central bank to buy in the open market a financial asset, such as government bonds, foreign currency, or gold. If the central bank sells these assets in the open market, the amount of money that the bank holds decreases, effectively destroying money.

The process does not literally require the immediate printing of new currency. A central bank account for a member bank can simply be increased electronically. However this will increase the central bank's requirement to print currency when the member bank demands banknotes, in exchange for a decrease in its electronic balance.

1 Possible targets of open market operations
2 Current goals and procedures of open market operations
3 How open market operations are conducted in the USA
4 See also
5 External links
- 5.1 Data

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Possible targets of open market operations

Besides interest rate targeting (the current aim of US and ECB operations), there are other possible targets of open markets operations: Under inflation targeting open market operations are directly used to achieve and maintain a target inflation rate (which - indirectly - is the stated goal of the ECB's monetary policy as well). A third possible target is the growth of the money supply, as was the case in the U.S. in the late 1970s through the early 1980s under Fed Chairman Paul Volcker.

Under a gold standard open market operations would be used to achieve and maintain a target gold price. The goal would be to keep the value of the currency constant relative to gold.

Under a currency board open market operations would be used to achieve and maintain a fixed exchange rate with relation to some foreign currency.

Economist Robert Mundell stated that when using open market operations it is only possible to pursue a single target at any given time. You can not use open market operations to target interest rates while being on a gold standard. Likewise if you are targeting interest rates then the price of gold will fluctuate.

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Current goals and procedures of open market operations

In the United States, as of 2006 the Fed sets an interest rate target for the Fed funds (overnight bank reserves) market. When the actual Fed funds rate is higher than the target, the desk will usually increase the money supply via a repo (effectively lending). When the actual Fed funds rate is less than the target, the desk will usually decrease the money supply via a reverse repo (effectively borrowing).

The European Central Bank has similar mechanisms for their operations; however, it uses a four-tiered approach with different goals: beside its main goal of steering and smoothing Euroland 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. The regular weekly "main refinancing operations" and the monthly "longer-term refinancing operations" provide liquidity to the financial sector, while ad-hoc "fine-tuning operations" (in the form of reverse or outright transactions, foreign exchange swaps and the collection of fixed-term deposits) aim to smooth interest rates caused by liquidity fluctuations in the market and "structural operations" are used to adjust the central banks' longer-term structural positions vis-a-vis the financial sector.

The Swiss National Bank currently targets the 3 month Swiss franc LIBOR rate, and borrows or lends Swiss francs directly with Swiss banks (in other words, without using repos) on an almost daily basis. These borrowings or loans are typically made for 1 day or 1 week, but may be as long as 1 month.

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How open market operations are conducted in the USA

In the U.S., the Federal Reserve (Fed) most commonly uses overnight repurchase agreements (repos) to temporarily create money, or reverse repos to temporarily destroy money. Alternatively, they may permanently create money by the outright purchase of securities. Very rarely will they permanently destroy money by the outright sale of securities. These trades are made with a group of about 22 banks or bond dealers who are called primary dealers.

Money is created with a repo simply by electronically increasing the reserve account at a bank, that is by issuing a new liability of the central bank. Money is destroyed with a reverse repo simply by decreasing the reserve account of a bank, that is by destroying a liability of the central bank. The Fed has conducted open market operations in this manner since the 1920's, through the Open Market Desk at the Federal Reserve Bank of New York, under the direction of the Federal Open Market Committee.

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