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Business Definition for: open market operations
Dictionary of Banking Terms
open market operations

purchase or sale of government securities by the Open Market desk at the Federal Reserve Bank of New York, as directed by the Federal Open Market Committee .

By buying and selling securities, mostly short-term Treasury obligations,i.e., Treasury bills, the Federal Reserve is able to: (1) meet the public demand for cash by adjusting bank reserves upward or downward, as needed, and (2) influence bank interest rates, including rates such as the Federal Funds (Fed Funds) rate that banks charge for short-term sale of excess reserves . Because reserve accounts at Federal Reserve Banks don't earn interest, banks try to hold reserves to a minimum or to the level of required reserves.

When the manager of the Fed's Open Market Desk at the Federal Reserve Bank of New York makes the decision to buy securities, the Fed writes a check on itself to the bank, or other institutional investor holding the securities, and deposits a check in a commercial bank. If the Fed buys $1 billion in Treasury bills, bank reserves are increased by that amount. Selling $1 billion in T-bills has the opposite effect, shrinking the reserves in the banking system, which tends to drive up the cost of credit, and interest rates. Because commercial bank reserve accounts don't earn any interest, banks try to hold their reserves at a minimum. When the Fed is worried that the inflation rate is rising, it pursues a tight money policy by selling securities. What results is higher interest rates, because the banks pass the added cost along to the borrowers.

The Fed also adds reserves to the banking system to meet the public's seasonal demand for cash. This demand for cash varies seasonally; it is highest in December, and lowest in late summer.

For these reasons, open market operations are the most flexible monetary tool the Fed has available in implementing its monetary policy objectives. Because commercial banks have about three-fourths of the nation's checking account deposits, the Fed, by managing the level of reserves in the banking system, is able to influence the nation's supply of money (the money supply or money stock), and the cost of credit. Both the Fed Funds rate, which is the market rate banks pay one another for nonborrowed reserves, and the bank prime rate are influenced to a large degree by the Fed's actions in open market operations.

Other tools of monetary policy are the discount rate and reserve requirements .

See also fiscal policy , matched sale-purchase agreement , reverse repurchase agreement , swap network
Related Terms:
fiscal policy

federal taxation and spending policies designed to level out the business cycle and achieve full employment, price stability, and sustained growth in the economy. Fiscal policy basically follows the economic theory of the 20th-century English economist John Maynard Keynes that insufficient demand causes unemployment and excessive demand leads to inflation. It aims to stimulate demand and output in periods of business decline by increasing government purchases and cutting taxes, thereby releasing more disposable income into the spending stream, and to correct overexpansion by reversing the process. Working to balance these deliberate fiscal measures are the so-called built-in stabilizers, such as the progressive income tax and unemployment benefits, which automatically respond countercyclically. Fiscal policy is administered independently of monetary policy, by which the Federal Reserve Board attempts to regulate economic activity by controlling the money supply. The goals of fiscal and monetary policy are the same, but Keynesians and Monetarists disagree as to which of the two approaches works best. At the basis of their differences are questions dealing with the velocity (turnover) of money and the effect of changes in the money supply on the equilibrium rate of interest (the rate at which money demand equals money supply).

matched sale-purchase agreement

action by the Federal Reserve to restrict the supply of funds (reserves) banks have available to lend. The Fed does this by selling securities to dealers and simultaneously agreeing to buy back those securities at a future date. Selling securities drains reserves from the banking system because dealers have to take out bank loans to finance their purchases.

Matched sale-purchase transactions usually have maturities of seven days or less, and are executed by the System Desk at the Federal Reserve Bank of New York, which carries out the monetary policy directives of the Federal Open Market Committee. The System Desk accepts dealer bids to buy securities, usually Treasury bills, until sufficient reserves have been absorbed. A matched sale-purchase agreement is the opposite of a repurchase agreement, which adds reserves.

reverse repurchase agreement
swap network

reciprocal short-term credit agreement between central banks to stabilize currency prices through intervention in the foreign exchange market.

Referring Terms:
discretionary monetary policy
Federal Open Market Committee (FOMC)
Copyright c 2006, 2000, 1997, 1993, 1990 by Barron's Educational Series, Inc. Reprinted by arrangement with Publisher.
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