A central bank uses open market operations to manipulate short-term interest rates by increasing or decreasing the money supply. A central bank decreases the money supply by selling short-term securities from its balance sheet. To expand the money supply, a central bank can buy short-term paper, loading assets onto its balance sheet.

Supply and demand dictates that interest rates decline when the money supply expands, as there is more money chasing a fixed amount of short-term securities. When inflationary pressures arise, the central bank looks to cool the economy by raising interest rates and contracting the money supply. By selling short-term securities from its balance sheet, the central bank soaks up excess money, taking this money out of circulation.

These activities have significant effects on asset prices. Expanding central bank balance sheets coincide with rising asset prices. By monetizing securities, there is more money in the economy, chasing fewer assets leading to higher prices. An example is the period following the Great Recession in which the Federal Reserve took on $3.6 trillion onto its balance sheet. The period of balance sheet expansion was from 2009 to 2014. During this time, the stock market tripled, and bonds rallied as well.

Following the 2008-2009 crisis, central banks have become more assertive in using open market operations to achieve their desired aims in terms of interest rates, especially with interest rates near the zero bound. At the zero bound, central banks engage in quantitative easing, which is an attempt to prevent deflation and improve financial conditions for an economy dealing with insufficient demand.

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