Open Market Operations
What is Open Market Operations?
Open market operations are the central bank's buying and selling of government bonds to change the money supply.
Buying bonds injects reserves and increases the money supply (expansionary); selling bonds removes reserves and decreases it (contractionary). They are the Federal Reserve's most-used monetary policy tool. They directly affect bank reserves and short-term interest rates.
Open Market Operations: a worked example
The central bank sells $50 million of government bonds to commercial banks while the required reserve ratio is 25%, so the multiplier is 1 / 0.25 = 4. Reserves drop by $50 million and deposits can contract by $50 million x 4 = $200 million. The bond market tells the same story through prices. Take a bond with a $1,000 face value paying a fixed $60 coupon each year, a yield of $60 / $1,000 = 6.0% at face value. The sale adds to the supply of bonds offered, and if the price falls to $960 the yield rises to $60 / $960 = 6.25%. Higher yields are higher interest rates, which is why an open market sale is contractionary.
The mistake students make with open market operations
The direction gets reversed constantly. Selling bonds feels expansionary because the central bank takes in money, but the cash flows out of bank reserves, which shrinks lending and pushes rates up. Buying bonds is the expansionary move, since the central bank pays banks with newly created reserves. Track where the reserves end up rather than who hands over the payment. The other reversal involves bond prices, which move opposite to yields, so a sale that drives prices down drives interest rates up.
Open Market Operations questions
Does the Fed buy or sell bonds to lower interest rates?
Buying bonds lowers interest rates. Payment for those bonds adds reserves to the banking system, the money supply grows, and the extra money chases bonds until their prices rise and their yields fall. Selling bonds does the reverse by draining reserves. A quick check is the direction of reserves, since anything that adds reserves is expansionary and anything that drains them is contractionary.
How do open market operations change bond prices?
An open market purchase raises demand for bonds and pushes their prices up, while a sale adds to the supply of bonds and pushes prices down. Yields move the opposite way because the coupon payment is fixed. A bond paying $60 a year yields 6.0% at a price of $1,000 and 6.25% at a price of $960, so a falling price is a rising interest rate.
Why does an open market sale shrink the money supply by more than the value of the bonds sold?
Selling $50 million of bonds drains $50 million of reserves from the banking system, and every dollar of lost reserves forces banks to unwind several dollars of deposits. Under a 25% requirement the multiplier is 4, so deposits can contract by $200 million. Banks call in loans or decline new ones until the deposits they still carry are backed by the reserves they still hold. The sale sets the reserve change, and the multiplier turns it into the larger deposit change.
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