Open Market Operations - How and Why They Are Conducted - Term Paper Example

? Open Market Operations – how and why they are conducted Ali Almuhannadi Open Market Operation (OMO) is a tool in monetary policy used by many governments through their central banks so as to influence the country’s economic situations. The major importance of using OMO is so as to help the government achieve the major objectives of monetary policies which includes; maintaining price stability, achieving a balanced economic growth and help a country achieve a full employment. The major activities involved in open market operation include the buying and selling of government securities which include the treasury bonds, bills and notes. During inflationary periods, there is a lot of money supply in the economy and the government needs to take drastic measures to control the money supply before the rate of inflation worsens. The securities are offered at a higher interest rate than those of private institutions which attract most investors to acquire them and relevant deductions are then made from their bank’s reserves/ accounts. This reduces the money supply in the economy as the amount of money available for consumption to the members will reduce and so will the amount of money available in commercial banks reserves for lending which means that even the lending rate will increase. When the money supply in an economy is limited, the government may decide to increase the supply by buying back part or most of its securities from the public. The government buys them back at the rates agreed during time of sale to the investor. This means that some money will be deposited in the respective investors’ accounts which will increase their disposable incomes and subsequently their spending. This will also increase the cash reserves of commercial banks hence they can lend money to the general public at lower rates. Open Market Operations – how and why they are conducted Marketing is something which must be performed in the right way possible in order to promote increased sale of a product. This should incorporate all components of a marketing plan and functions in addition. The marketing plan in that manner becomes the central application, which has the competency to improve the sales of a product in the global perspective. The marketing of a product largely relies on the marketing plan established in any given organization. Open markets operations are the principle tool of U.S monetary policy in which central banks buy and sell bonds and securities. The principle has been in use for several years and it functions to maintain reserve balances. It is worth noting that the United States employs open market operations through the Federal Reserve Bank. There are several activities, which are conducted by the Federal Reserve Bank in order to make such operations worth running. However, this is a paper that critically explores open markets operations in terms of how and why they are conducted. It is worth noting that a critical review of the area under discussion is performed from a broad point of view. The Federal Reserve System was established in 1913 when the congress passed the Federal Reserve act. Although it is independent of the government, it is accountable to the congress because the congress can amend the Federal Reserve act when necessary. The Fed is called a "decentralized" central bank. By manipulating reserve balances the Federal Reserve can control the price of reserves in the market. The theory of open markets operations is quite simple; the fed buys securities when it wants to increase the flow of money and credit, and sells securities when it wants to reduce the flow of money and credit (Harvey 4). What they designate as their target interest rate speaks for what they are trying to fight. If they lower the interest rate they are fighting recession. If they raise the interest rate they are fighting inflation. The fed can choose from among many financial instruments to conduct open market operations: corporate bonds, corporate stocks, commercial paper, etc. it uses treasury securities for various reasons. In one way or another, the fed is also accountable for any emerging mistake in relation to the open market operations (Thornton 553). In that sense, every activity performed by the fed is given the first priority in order to deliver quality services. When there is need to contract the money supply in the country, the central bank starts selling securities in the open market. Since people have more confidence in the central bank than other commercial banks, they buy securities issued by the central bank either by withdrawing their money from the commercial banks or using their hoarded cash (Roche 1). This way money begins to flow into the central bank and the cash balances of the commercial banks begin to decrease. The commercial banks are therefore forced to reduce their lending; this leads to a fall in investment, output, employment and income. The overall effect is a fall in prices of commodities. The central bank begins to buy securities in the open market if it wants to increase the supply of money. If the supply of money is increased, people will deposit more money in commercial banks. With a rise in cash reserves in banks, they are able to create more money supply. There are various reasons why open market operation is an effective monetary policy tool. The first reason is because they are highly flexible and can be used in widely varying amounts. Secondly, they are easily reversible in time. Thirdly, they can be used in widely varying amounts and fourth, unlike other instruments of monetary policy, they do not involve any public announcements and hence they do not have any announcement effects. According to research, for open market operations to be successful, at least three conditions are necessary: It is necessary that the central bank is in a position to buy and sell government securities. It is necessary that as the central bank pursues these operations that it considers that its main goal is monetary control. It is necessary that the market for government securities be well developed and organized. Fed’s board of governors meets with the president of the Federal Reserve bank of New York every month or two. This meeting is also attended by a rotating set of four of the presidents of the other regional reserve banks. This assembly is called the federal open market committee (FOMC) and it issues directives to the bond trading-desk of the federal reserve bank of New York concerning the type and quantity of open market operations it should engage in. once the committee deems that economic conditions warrant a change in the money supply, they command the buying or selling of a specific amount of U.S treasury securities through the New York Fed president (Thornton 558). The New York trading desk is then responsible for the implementation of the actual trades. It carries out the trades by sending messages to a selected group of securities dealers who specialize in the U.S treasury securities. These dealers are given about fifteen minutes to respond back with an indication of their willingness to participate in the exchange of securities. The words ‘open’ in open market operations means that the exchange trade is open any securities dealers willing to participate. The trading desk then responds to the willing dealers that the terms of the exchange are acceptable (Roche 1). This response is usually given within five minutes. Once all parties are in agreement with the terms of exchange, the resulting transactions are done pretty much like any other. When the committee wants to increase the supply of money in the economy via an open market operation, it directs the desk to buy treasury bonds on the bond market. In purchasing the bonds the desk gives the bond seller a check written on the Federal Reserve. The buyer then deposits the check in its bank, which then presents it to the Federal Reserve for payment. The buyer’s account is then credited with an amount equal to the amount of the check by the Federal Reserve. The implication of this is that the Fed ends up holding additional Treasury bonds while the buyer ends up with a larger cash deposit. The buyer’s bank then finds itself holding excess reserves and this triggers the process of deposit creation. However, in open market operations, there is no offsetting reduction of reserves at other commercial banks as would occur if normal checks were issued. The accounting balance is achieved by addition of extra U.S treasury securities to the assets of the Fed. This implies that the banking system receives a net gain in reserves with which it can use to make loans, expand the money supply and create deposits. Banks are then forced to offer loans while charging lower interest rates. When the Fed sells treasury securities, it directs securities dealers to write checks on the commercial bank accounts they use. When these checks are processed, commercial banks’ reserves are deducted. However, unlike in the normal check processing, there is no offsetting additional reserves added to commercial banks. The balance is then achieved by reduction of U.S Treasury securities on the asset side of the Fed. The result of this is that the banking system ends up with a net loss in reserves. This implies that the loaning capability of the commercial banks is reduced and thus creates fewer deposits and contracts the money supply. Commercial banks then are forced to charge higher interest rates because fewer reserves are available for lending. Conclusion As a point of conclusion, the discussion has explored open market operations and the way through which they are conducted. Through providing various relevant examples and illustrations, the paper sheds light on the importance of the subject to the reader. It is worth noting that some economists are of the view that open market operations can hardly achieve much if they are not supplemented with other monetary policy tools. Gupta and Mandal in contrast held the view that if open market operations are undertaken extensively and skillfully can attain the objective without the help of other monetary policy tools, such as the discount rate policy, if they are supplemented by state organization of investment or by compensatory planning or public works. The general view however, is that open market operations must be supplementary to the bank rate policy. Works Cited Harvey, Campbell. & Huang, Roger. The Impact of the Federal Reserve Bank’s Open Market Operations. National Bureau of Economic Research, (2001):1-40. Print. faculty.fuqua.duke.edu/~charvey/Research/.../W3_The_impact_of.pdf? Roche, Cullen. A Case Study on the FED’s Permanent Open Market Operations. Retrived from: http://pragcap.com/case-study-feds-pomo Thornton, Daniel. Open Market Operations and the Federal Funds Rate. Federal Reserve Bank of St. Louis Review, 89.6(2007):549-70. 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