What Does Open Market Operations Mean?
Open market operations (OMO) refer to a central bank's buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. Securities' purchases inject money into the banking system and stimulate growth, while sales of securities do the opposite and contract the economy.
The Federal Reserve (Fed) facilitates this process and uses this technique to adjust and manipulate the federal funds rate, which is the rate at which banks borrow reserves from one another.
Open Market Operations Explained
Understanding Open Market Operations (OMO)
Open market operations (OMO) is the most flexible and most common tool that the Fed uses to implement and control monetary policy in the United States. However, the discount rate and reserve requirements are also used.
The Fed can use various forms of OMO, but the most common OMO is the purchase and sale of government securities. Buying and selling government bonds allows the Fed to control the supply of reserve balances held by banks, which helps the Fed increase or decrease short-term interest rates as needed.
Federal Open Market Committee
The Federal Open Market Committee (FOMC) is the Fed's committee that decides on monetary policy. The FOMC enacts its monetary policy by setting a target federal funds rate and then implementing OMO, discount rate, or reserve requirement strategies to move the current federal funds rate to target levels. The federal funds rate is extremely important to control because it affects most other interest rates in the United States, including the prime rate, home loan rates, and car loan rates.
The FOMC normally uses Open Market Operations first when trying to hit a target federal funds rate. It does this by enacting either an expansionary monetary policy or a contractionary monetary policy.
Expansionary Monetary Policy
The Fed enacts an expansionary monetary policy when the FOMC aims to decrease the federal funds rate. The Fed purchases government securities through private bond dealers and deposits payment into the bank accounts of the individuals or organizations that sold the bonds. The deposits become part of the cash that commercial banks hold at the Fed, and therefore increase the amount of money that commercial banks have available to lend. Commercial banks actively want to loan cash reserves and try to attract borrowers by lowering interest rates, which includes the federal funds rate.
When the amounts of funds available to loan increases, interest rates go down. A decrease in the cost of borrowing means that more people and businesses have access to funds at a cheaper rate. This leads to less savings and more spending. Increased spending fuels the economy, leading to lower unemployment.
Contractionary Monetary Policy
The Fed enacts a contractionary monetary policy when the FOMC looks to increase the federal funds rate and slow the economy. The Fed sells government securities to individuals and institutions, which decreases the amount of money left for commercial banks to lend. This increases the cost of borrowing and increases interest rates, including the federal funds rate.
When the cost of debt increases, individuals and businesses are discouraged from borrowing, and will opt to save their money. The higher interest rate means that the interest in savings accounts and certificates of deposit (CDs) will also be higher. To take advantage of the savings rates, entities will spend less in the economy and invest less in the capital markets, thereby, slowing inflation and economic growth.