Open Market Operations. An Overview

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Open market operations are the main instruments of the central bank and form the focus of the monetary policy. They are used to control interest rates, the liquidity position and showing the monetary policy stance.

Through the open market, commercial banks receive most of their money against the pledge of collateral (eg securities). The central bank offers commercial banks certain fixed income securities to purchase securities from commercial banks.

This entails satisfying the demand as regards base money at the target rate by purchasing and selling government securities, as well as other financial instruments. Such an implementation is steered on the basis of various monetary targets such as inflation, interest rates or exchange rates.

In the event that a higher demand for base money is experienced measures are taken so as to uphold the short term interest rate. The reserve bank buys a financial asset such as government bonds, foreign currency or gold in the open market to pay for this.

In turn, bank reserves are transferred to the sellers bank, and the sellers account is credited, consequently increasing base money in the economy. And the opposite of such a move translates to a decrease in base money in the economy.

With the fixed rate tender procedure, the interest rate offered for central bank money is fixed. Commercial banks make bids for the desired amounts of money they want to acquire. The allocation ratio is calculated by comparing the total proposed allotment based on the total offer amount.

The problem of the fixed rate is that because of low interest rates the commercial banks tend to make higher bids quantity than they actually need. And it is cut in the subsequent apportionment (pro-rata allocation).

From the perspective of commercial banks, securities repurchase transactions are effected via securities they offer, in turn the commercial bank receives funds in the form of central bank money.

The method of variable rate tenders the rate at which the central bank can conduct its open market operations. The central bank sets a minimum bid, that is, the minimum interest rate at which it is carrying out open market operations (as a signal for the monetary policy stance).

The allocation of central bank money is carried out under procedures in which all bidders of the tender process will be served on the basis of the interest rate they have offered. The lowest interest rate that can be still served as a (partial) assignment, is the marginal rate.

 

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