Open Market Operations

What It Is and How It Works

Open Market Operations are the buying and selling of securities (such as bonds or bills) by the Central Bank. It is one of the main monetary policy tools for altering the amount of money in circulation and the interest rate.

When the Central Bank “buys” a bond in the open market, it gives in exchange a dollar amount that is incorporated into the economy's circulating currency. The opposite occurs when a Central Bank sells a bond.

The Policy Impact

Central Banks (CBs) are the institutions in charge of implementing monetary policies based on different objectives, among which price stability and economic growth stand out.

When buying a bond or a bill, the Central Bank in turn injects money into the economy, which allows to reduce the interest rate and -as can be better understood by looking at the interest rate section- that can stimulate consumption and investment.

When the CB sells a bond instead, it withdraws money from the economy, raising the interest rate and making borrowing more expensive, which in turn leads to a fall in investment and therefore in the economy.

Another way to think about the relationship between open market operations and the interest rate can be through the price of bonds. Consider the following: each bond has a face value (the total amount it will pay at maturity) and a price at which it is traded in the market (market value). The difference between them is nothing more than the interest that bond will pay.

For example: if the value of a bond maturing in 10 years is $1100, and today it is traded at $1,000 in the secondary market, then the total interest paid on that bond for whoever buys it will be $100 (equivalent to a rate of 1% per annum). Now the Central Bank appears, with its well-known open market operations. In particular, the Central Bank decides to go out and buy many securities like the one mentioned above, that is, to increase the demand for those bonds. What happens to the price of a good when its demand increases? Exactly, it will go up. In our case, we have that the price now rises to $1050. And then, what happened to interest? Since interest can be thought of as the difference between the nominal value and the market value, and the latter changes, we know that the interest will have to change as well. It will now be $1100 (face value) - $1050 (market value) = $50 (equivalent to a rate of 0,5% per annum). Do you see how buying a bond on the open market has resulted in a lower rate?

Stakeholders and Political Implications

The first to be affected by open market operations are the bondholders. We are talking above all about banks and investment funds. Remember that if the Central Bank decides to sell securities in order to contract the money supply and increase the interest rate, then the price of the assets of all these holders will rise. The opposite happens when the Central Bank buys securities. As a consequence, and fundamentally through the interest rate, (although it can also be through other channels such as the exchange rate), its effects are transmitted to the rest of the economy, affecting mainly those sectors that are more leveraged (indebted). We can think for example in the case of a company that is deciding whether to expand its manufacturing plant, or a family that is thinking of taking a mortgage loan to buy a house. If the interest rate rises, it will probably discourage them from doing so.

Some Debates Among Economists

Although there are differences among economists as to whether monetary policy can have an effect on economic growth in the long term, there is a majority consensus that in the short term it has non-neutral effects. In this sense, there are discussions regarding the best instrument for the Central Bank to affect economic decisions, and not all agree that open market operations are ideal. This is because, given that the main channel of transmission of monetary policies is the interest rate, there may be more direct ways to affect the decisions of the actors, such as setting the interbank overnight interest rate.