The New Palgrave Dictionary of Economics

2018 Edition
| Editors: Macmillan Publishers Ltd

Open-market Operations

  • Stephen H. Axilrod
  • Henry C. Wallich
Reference work entry
DOI: https://doi.org/10.1057/978-1-349-95189-5_1301

Abstract

An open-market operation is essentially a transaction undertaken by a central bank in the market for securities (or foreign exchange) that has the effect of supplying reserves to, or draining reserves from, the banking system. Open-market operations are one of the several instruments – including lending or discount-window operations and reserve requirements – available to a central bank to affect the cost and availability of bank reserves and hence the amount of money in the economy and, at the margin, credit flows.

An open-market operation is essentially a transaction undertaken by a central bank in the market for securities (or foreign exchange) that has the effect of supplying reserves to, or draining reserves from, the banking system. Open-market operations are one of the several instruments – including lending or discount-window operations and reserve requirements – available to a central bank to affect the cost and availability of bank reserves and hence the amount of money in the economy and, at the margin, credit flows.

Theory and Function

A distinctive feature of open-market operations is that they take place at the initiative of the monetary authority. They provide a means by which a central bank can directly and actively affect the amount of its liabilities for bank reserves, increasing them by purchases of securities and decreasing them by sales. With reserve provision at the initiative of the central bank, open-market operations facilitate control of the money supply and, from a short-run perspective, the pursuit of a stabilizing economic policy by the central bank and, from a longer-run perspective, of an anti-inflationary policy.

By contrast, in the operation of a central bank’s lending function, the provision or liquidation of reserves is at the initiative of private financial institutions. To the extent that this facility is employed too actively or not actively enough and is not offset by the central bank through open-market operations, or by an appropriate discount rate, control of the volume of reserves, and, ultimately, the money supply, is weakened.

When open-market operations play the primary role in monetary-policy implementation, such as in the United States, the discount window still serves an important function in the monetary process. Indeed, in the short run, demands at the discount window are not independent of the amount of reserves supplied through the open market. For example, as a central bank restrains reserve growth by holding back on security purchases, some of the unsatisfied reserve demand will at least for a time shift to the discount window. In general, changes in the demand for borrowing will in practice provide some offset to provision of reserves through open-market operations. This may make it more difficult for a central bank to control bank reserves precisely through open market operations. However, precise control is probably not desirable in the short run because demands for, and needs for, money and credit in dynamic, highly active economies are quite variable. In that sense, the discount window provides a safety valve through which reserves can be provided to maintain a suitably elastic currency and to avert disorderly market conditions.

An open-market purchase essentially replaces an interest-earning asset on the books of banks (either a government security or a loan to some entity holding a government security) with a claim on the central bank – that is, with a reserve balance that has been created for the purpose of acquiring the security. This reserve balance is then ‘excess’ to the banking system. In the process of converting these non-interest-earning excess balances into interest-earning assets, banks will in turn make loans or purchase securities. That will tend to keep interest rates lower than they otherwise would be and lead to an expansion of the money supply through the well-known multiplier process as the original excess reserves turn into required reserves. The associated amount of money will be a multiple of the amount of reserves, with the multiple depending on the required reserve ratio and on the amount of excess reserves banks in the end want to hold at given levels of interest rates.

The power of open-market operations as an instrument of policy does not, however, depend in its essentials on banks being required to hold reserves or being required to hold a high or low fraction of deposits as reserves at the central bank. That might affect to a degree the precision of the relationship between open-market operations and money. But the power of open-market operations to influence the economy derives essentially from the ability of the central bank to create its own product – whether it takes the form of bank reserves, clearing balances, or currency in circulation – without the need to take account of the circumstances that influence ordinary business decisions, such as costs of materials, profit potential, and the capacity to repay debt incurred. Even in the unlikely event that the banks, in the absence of reserve requirements, chose to carry zero reserves and to rely entirely on the discount window, the central bank would have large liabilities outstanding in the form of currency through which it could exert pressure on banks by means of open-market operations. In the United States about three-quarters of the central bank’s assets reflect currency liabilities.

In a sense, the product of open-market operations – the non-borrowed portion of the monetary base (roughly the sum of the central bank’s deposit or reserve liabilities plus currency in circulation) – can be viewed as being created from outside the economy. It is ‘outside’ money, exogenous to the economic process, but capable of strongly influencing that process. If the central bank continues to create a product for which there is no need or which the participants in the economy do not wish fully to accept, the economy will devalue that product; excessive money creation will cause the price of money relative to other products to fall. That effectively occurs through a rise in the general price level domestically and devaluation of the currency internationally.

Open-market operations in those countries which have sufficiently broad and active markets so that they can be the central instrument of policy are of course attuned to the nation’s ultimate economic objectives and to the intermediate guides for over-all monetary policy used to accomplish these objectives; these guides may encompass money supply, interest rates, or exchange rates. In implementing policy on a day-to-day basis, however, open-market operations require additional guides in those cases where the intermediate objectives of policy are quantities, such as the money supply, that are not directly controllable through the purchase or sale of securities.

In most countries, operations are guided on a day-to-day basis by some view of desirable tautness or ease in the central money market, as judged by an appropriate short-term interest rate, complex of money-market rates, or degree of pressure on the banking system. As money-market and bank reserve pressures change, the banking system, financial markets generally, and the public make adaptations – through changes in interest rates broadly, lending terms and conditions, liquidity and asset preferences – that with some lag lead to attainment of money supply objectives or economic goals more broadly.

It has been argued, chiefly by those who would like policy to focus more or less exclusively on a money supply intermediate target, that open-market operations should be guided not by money-market conditions or the degree of pressure on the banking system but by the total quantity of reserves or monetary base. Because open-market operations are at the initiative of the central bank, they are construed as especially well suited to attainment of such quantitative reserve objectives. Reserves or the monetary base as a guide are thought to bear a more certain relationship to a money-supply intermediate guide than do money-market conditions because the former depend on the multiplier relationship between reserves or the base and money and not on predicting how markets and asset holders will react to a given change in interest rates. However, in practice the multiplier relationship itself is variable (in part because of varying reserve requirements or reserve balance practices behind differing deposits in measures of money) and is not independent of interest rates; for instance, rates affect the demands for both excess and borrowed reserves.

Techniques

A variety of techniques are available to implement open-market operations. Securities can be purchased or sold outright. The securities may be short- or long-term, although because short-term markets are generally larger and more active most transactions take place in that market.

Open-market transactions may also be undertaken through, in effect, lending or borrowing operations – by purchasing a security with and agreement to sell it back, say, tomorrow or in a few days, or by selling a security with an agreement to buy it back shortly. Whereas outright transactions take place at current market rates on the securities involved, these combined purchase and sale transactions (termed repurchase agreements) yield a return related to the going rate on collateralized short-term loans in the money market. Repurchase agreements have the advantage of greater flexibility. When they run out, after being outstanding overnight or for a few days only, reserves are withdrawn or provided automatically. Outright purchases or sales create or asorb permanent reserves requiring more explicit action to reverse.

Open-market operations are generally conducted in governmental securities, since that is usually the largest and most liquid market in the country. In the United States, domestic operations are confirmed by law to US government or federal agency securities and all operations must be conducted through the market; purchases cannot be made directly from the government. A large, active market is essential if the central bank is to be able to effect transactions at its own initiative when and in the size required to meet its day-to-day objectives.

The traditional responsibility of central banks for maintaining the liquidity of markets and averting disorderly conditions affects methods of open market operations. In the United States, the bulk of day-to-day open-market operations are undertaken to offset variations in such items as float, the Treasury cash balance, and currency in circulation that affect the reserve base of the banking system. On average per week, such factors absorb or add about 4 per cent (the equivalent of $11/2 billion) of the reserve base in the United States. Without offsetting open market operations – sometimes termed ‘defensive’ operations – typically undertaken through repurchase transactions, money-market conditions and rates would tend to vary sharply from day to day, unduly complicating private decision-making and possibly frustrating the central bank’s purposes with respect to controlling the growth of the money supply or the level of interest or exchange rates.

Open-market operations conceptually can be employed to affect the yield curve – for example, to maintain short-term rates while exerting downward pressure on long-term rates. By shifting the composition of its portfolio, the central bank can change the supply of different maturities in the market. An effort to do this in the United States in the early 1960s was not clearly successful. In part, this may be because such an operation requires active cooperation by the Treasury. More fundamentally, most economists have come to believe that expectations so dominate the term structure of interest rates that the central bank, even if aided by a like-minded governmental debt management, would have to engage in massive changes in the maturity structure of securities in the market in order to produce more than a small impact on the shape of the yield curve.

Apart from operations in governmental securities, some central banks undertake open-market operations in foreign exchange. This may be done in an effort to influence the course of exchange rates while at the same time offsetting any effect on bank reserves or other money-market objectives – termed sterilized intervention. However, in certain countries the foreignexchange market may be the chief avenue available for open-market operations, as is typically the case for small countries in which foreign trade represents a large fraction of their gross national product and exchange-market transactions a large portion of total activity in the open market. In such cases, open-market operations in foreign exchange also tend to affect the bank reserve base either because there is little scope to offset them through domestic markets or because there is little desire to do so if the central bank has a relatively fixed exchange rate objective.

Relation to Governmental Budgetary Deficits

There is no necessary relationship between open-market operations and the financing of budgetary deficits. In a country like the United States open-market purchases are undertaken only as needed to meet money supply and overall economic objectives; they are not increased because a budgetary deficit is enlarged nor decreased when a deficit diminishes. The government must meet its financing needs by attracting investors in the open market paying whatever market interest rate is necessary.

An enlarged deficit would itself lead to increased open-market purchases only if the monetary authority deliberately adjusted its objectives to permit an expansion of bank reserves and money to help finance the government, in which case the deficits would indirectly, through their influence on monetary-policy decisions, lead to inflationary financing. This occurred as a means of war finance during World War II in the United States when the central bank purchased government securities from the market at a fixed ceiling price, thus in effect monetizing the debt; price controls were employed in an effort to suppress the inflation.

But since the early 1950s, debt finance by the US government has had to meet the test of the market unaided by central-bank open-market purchases. Confidence that the central bank will not finance the government deficit is essential to a sound currency. A financial system in which the central bank can refuse to fund the deficit also can provide a powerful incentive to keep deficits from burgeoning.

The typical instances of central-bank monetization of the debt in recent decades have occurred in countries – usually not highly developed ones – with persisting large budgetary deficits who are unable to attract private investors at home or abroad because interest rates offered are artificially low, or the domestic market is undeveloped, or because of a lack of confidence in the security and the currency domestically or on the part of foreign investors. The central bank is then more or less forced to acquire securities directly from the government, automatically creating reserves and money, and leading to inflation and perhaps hyperinflation as the process continues. In those cases, a halt to monetization of the debt through central bank purchases depends essentially on greatly reducing, if not eliminating, budgetary deficits.

It must be recognized, to be sure, that a government deficit may lead to pressures on interest rates that the central bank, usually ill-advisedly, may wish to resist. By encouraging expansion of bank credit and money supply, through open-market operations or otherwise, the central bank may indirectly finance a deficit.

The number of countries in which effective open-market operations can be conducted is surprisingly limited. Required is a securities market sufficiently deep so that the central bank can make purchases and sales sufficient to achieve its reserve objectives without significantly affecting the price of the securities. Otherwise it will be constrained by fear of unintended price effects and would in any event be engaging more in interest-rate manipulation than in control of reserves. Such comparatively price-neutral operations, if possible at all, are feasible usually at the short rather than at the long end. It requires a market for Treasury bills or similar instruments such as exists in, for instance, the United States, the United Kingdom and Canada, but that does not at this time in, for example, Germany and Japan. In the United Kingdom open market operations, in former years, were conducted in Treasury bills; today, commercial bills are primarily employed. Thus, central banks have varying capacities to undertake open market operations; in some cases, where markets for short-term instruments are limited, operations may not be entirely at the initiative of the central bank, nor at a market price in contrast to one set by the central bank (although the price set by the central bank may be based on market conditions).

See Also

Bibliography

  1. Bank of England. 1984. The development and operation of monetary policy, 1960–1983, 156–164. Oxford: Clarendon Press.Google Scholar
  2. Board of Governors of the Federal Reserve System. 1984. The Federal Reserve System: Purposes and functions, 7th edn. Washington, DC.Google Scholar
  3. Federal Reserve Bank of New York Quarterly Review 10(1), Spring 1985, 36–56. (Reports for earlier years are available in the same publication.Google Scholar
  4. Meek, P. 1982. US monetary policy and financial markets. New York: Federal Reserve Bank of New York. Monetary policy and open market operations in 1984.Google Scholar

Copyright information

© Macmillan Publishers Ltd. 2018

Authors and Affiliations

  • Stephen H. Axilrod
    • 1
  • Henry C. Wallich
    • 1
  1. 1.