Interest rates are indirectly affected by open market operations (OMOs); the buying and selling of government securities in the public financial exchanges. OMOs is a tool in monetary policy that allows a central bank to control the money supply in an economy. Depending on the condition of the economy, central banks will seek to implement either contractionary or expansionary monetary policy.
- Central banks employ a variety of tools as part of monetary policy to effect change in an economy.
- One of the tools used by central banks is open market operations; the buying and selling of securities.
- A contractionary policy will involve selling securities to banks, thereby reducing their reserves. An expansionary policy will involve buying securities from banks, thereby increasing their reserves.
- The more reserves a bank has, the more it can lend and reduces interest rates to do so. The fewer reserves a bank has, the less it has to lend and increases its interest rates.
Open Market Definition
Open Market Operations and Interest Rates
Under a contractionary policy, a central bank sells securities on the open market, which reduces the amount of money in circulation. Expansionary monetary policy entails the purchase of securities and an increase in the money supply. Changes to the money supply affect the rates at which banks lend to one another, a reflection of the basic law of supply and demand.
In the U.S, the federal funds rate is the interest rate at which banks borrow reserves from one another overnight to meet their reserve requirements. This is the interest rate that the Federal Reserve targets when conducting OMOs. Short-term interest rates offered by banks are based on the federal funds rate, so the Fed can indirectly influence interest rates faced by consumers and businesses by the sale and purchase of securities.
When the Fed buys securities from banks, this in theory increases their money supply; they have more money to lend. When banks have more money to lend, they want to offload that money by earning interest on it rather than having it sit idle. When this happens, a bank will reduce its interest rates to make borrowing attractive.
Conversely, when the Fed sells securities to banks, this means they have less money on hand to lend out. The less money on hand means that banks will increase interest rates to earn the most on their limited supply of reserves.
In 1979, the Fed under Chair Paul Volcker began using OMOs as a tool. To combat inflation, the Fed started selling securities in an attempt to reduce the money supply. A year later, the number of reserves shrank enough to push the federal funds rate as high as 20%. 1981 and 1982 saw some of the highest interest rates in modern history, with average 30-year fixed mortgage rates rising above 16%.
Conversely, the Fed purchased over $1 trillion in securities in response to the 2008 recession. This expansionary policy, called quantitative easing, increased the money supply and drove down interest rates. Low interest rates helped stimulate business investment and demand for housing.
What Are Open Market Operations?
Open market operations is one of the main tools that a central bank uses to affect monetary policy in an economy. Open market operations involves buying and selling securities to either expand or contract the economy. Selling securities on the open market contracts the economy while buying securities expands it.
What Tools Does the Fed Use for Monetary Policy?
Tools that the Fed uses to control monetary policy include the reserve requirement, open market operations, the discount rate, and quantitative easing. Changes to each of these will have a contractionary or expansionary effect.
How Do Open Market Operations Affect the Federal Funds Rate?
As part of open market operations, when the Fed buys securities from banks, it increases the money supply and the banks' reserves, which results in a reduction in the fed funds rate. Conversely, when the Fed sells securities to banks, this reduces the money supply and the banks' reserves, which increases the fed funds rate.
The Bottom Line
One of the tools used to affect monetary policy by a central bank is open market operations; the buying and selling of securities. Depending on whether the central bank wants to employ a contractionary or expansionary monetary policy, it will sell or buy securities from banks, respectively.
This impacts the number of reserves that banks have on hand which affects the interest rates they charge on lending. The more reserves they have from selling securities, the lower the interest rates charged. The fewer reserves they have from buying securities, the higher the interest rates charged.