OMOs or Open Market Operations are a commonly used tool by Central Banks to administer the monetary policy. Central Banks try and control the price and quantity of money in the economy through the implementation of the monetary policy, price of money being interest rates. In the ensuing paragraphs, we will see how OMOs are affectively used by central banks to target the general level of inflation and interest rates in the economy.
Inflation in an economy is high when money is easily available for spending. Money is easily available due to low-interest rates prevailing in the economy. Therefore, interest rates need to move up and the supply of money in the economy needs to come down to check the inflation. This is where OMOs come in.
OMOs are generally conducted through buying and selling of government securities. To increase the price of money (interest rates) or decrease the quantity of money in the economy, the central bank of the country will sell government securities through OMOs. As these securities are bought up by individuals and institutions, money gets sucked out of the economy and there’s not much money left with banks for lending. This, in turn, puts upward pressure on the interest rates as money becomes a scarce commodity and is not so easily available anymore. Now as money becomes expensive demand gradually falls off and inflation starts to come off its highs.
This is called a contractionary monetary policy, where the economy is deliberately contracted to check the heating up of the economy.
Now consider the case when the economy is in recession. When the economy is in recession, inflation is as good as non-existent as demand is low and the economy needs to be kick-started. For this, the supply of the money in the economy and in the hands of the people needs to be increased so that they may spend more freely and push up demand and therefore inflation. OMOs once more enter the picture here.
To increase the supply of money in the economy, the central bank will purchase government securities from individuals and institutions. This pumps money into the economy and puts an excess of money in the hands of banks for lending. This, in turn, puts downward pressure on interest rates. As interest rates fall people borrow more for spending which increases demand and inflation and spurs the economy towards growth. This is called an expansionary monetary policy which is used to increase demand.
This is how central banks use OMOs for targeting the level of inflation and interest rates in the economy on an ongoing basis. The monetary policy however often needs to be adjusted to reflect the source of the inflation. A contractionary monetary policy will work when inflation is high due to increased demand. However, inflation can also be a result of decreased supply. Implementation of a contractionary monetary policy, in this case, will only make the situation worse. Similarly, if the inflation is low due to an excess of supply, an expansionary policy will not work.
This article is written by Aarwin’s Guide to CFA.