An open market operation is an activity of buying and selling securities by the central bank. It is an integral part of monetary policy tools, apart from policy interest rates and the change in reserve requirements ratio. The aim is to influence liquidity and the money supply in the economy.
When open market operations involve massive scale purchases of securities, they are known as quantitative easing.
Generally, the securities involved are usually short-term government securities held by commercial banks.
How open market operation works
The central bank carries out open market operations to influence the supply of money in the economy. The purchase (sale) of government securities increases (decrease) commercial bank reserves, leading to an increase (decrease) in the price of government securities. Finally, the purchase (sale) indirectly results in a decrease (increase) in interest rates.
Expansionary monetary policy
Purchasing government securities increases the money supply. We call this policy an expansionary monetary policy. The expansionary policy aims to stimulate economic growth and encourage inflation to rise.
When buying government securities, the central bank hands over the money, and as compensation, the central bank holds the securities. In other words, the central bank injects money into circulation. Because receiving cash, the bank could make more loans. Through the process of creating money, the effect of the money multiplier works and increases the money supply in the economy.
When more money is circulating, liquidity is abundant, and interest rates fall. A decrease in interest rates triggers an increase in aggregate demand. Higher demand stimulates businesses to produce more and the economy to grow.
Contractionary monetary policy
When the government sells government securities, money flows from commercial bank accounts to the central bank. Now, banks have less liquid funds available to lend. As a result, the money supply contracts.
A contraction of the money supply causes tighter liquidity, pushing up interest rates. Higher interest rates make loans more expensive. Households should reduce consumption, especially for durable goods. Businesses should also reduce investment in capital goods because investment costs become more expensive.
Declined consumption and investment contracts aggregate demand. Businesses respond by reducing production. As a result, economic growth slowed, and inflationary pressures weakened.