Monetary Policy
Open Market Operations: How Central Banks Move Money Around
What It Is and How It Works
Open Market Operations (OMOs) take place when a central bank sells or purchases securities, such as government bonds, to manage the supply of money in the economy and to impact interest rates. As described in the interest rate section, the central bank injects money into the economy when it purchases bonds. When it sells bonds, it withdraws money.
The objective of OMOs is to make the economy expand and maintain stable prices. When the central bank purchases bonds, it raises the supply of money and decreases interest rates, which makes borrowing less expensive and induces individuals to spend and invest. When it sells bonds, it decreases the supply of money, increases interest rates, and decelerates borrowing and spending. You can consider interest rates to be the cost of money: when the money supply rises, its "price" (the interest rate) will go down, and vice versa.
Here's an example:
Let's say a bond that in 10 years will be worth $1,100 is now selling for $1,000. The buyer's return (or interest) is $100, or 1% per year. Now let's say the central bank begins purchasing large amounts of these bonds. Demand up, price goes up, and now the bond is $1,050. It's still worth $1,100 at maturity, but now the interest is just $50. That's a 0.5% return per year. So, when the central bank purchases bonds and pushes prices up, it lowers interest rates. That's how OMOs function.
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Policy Impact
OMOs affect the economy by changing how much money is circulating and by influencing interest rates. Buying bonds increases the money supply and lowers interest rates, which boosts borrowing, spending, and investment. Selling bonds does the opposite—less money in the economy and higher interest rates, discouraging borrowing. This matters to businesses deciding whether to expand or to families considering taking out loans. Higher interest rates tend to make both more cautious.
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Stakeholders and Political Implications
Banks, investment funds, and other bondholders are directly affected by OMOs. Prices rise when the central bank buys bonds, helping those who already own them. When it sells, prices drop. These changes ripple through the economy, primarily because they affect interest rates. Since interest rates influence almost every economic decision (from getting a loan to building a factory), OMOs can have wide political and economic effects.
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Debates Among Economists
Most economists agree that OMOs help manage the economy in the short run. However, there is debate about how effective they are compared to other tools. Adjusting the official interest rate (like the rate banks charge each other overnight) may be a better way to guide the economy.