How exactly do open market operations of a central bank work?

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Question: 

Most standard books on economics state that to increase the money supply of a state the state's national bank will buy bonds from the open market . This confuses me a lot as buying bonds should actually reduce the money supply. Suppose the fed bought a bond at price P . This would mean that they have now bought the right to get P + i (i= interest) at the time of bond expiry. They would have put p into the system and taken out P + i from the system , REDUCING the money supply by i (= {P+i} - { P}). Please help me clear the confusion.

Answer: 

To understand Open Market Operations (OMOs), we first need to understand, Government securities. Government securities are a tradeable instrument issued by the Government (Treasury securities in case of US). They derive their value from the government's commitment and creditworthiness, making them a secure investment that recognizes the government's responsibility to fulfill its debt obligations. They are also purchased and held in large quantities by financial institutions as well as individuals. They are a safe investment and carry practically no risk of default.

OMOs are conducted by a central bank to adjust the liquidity conditions in the market. It entails sale/purchase of Government Securities to / from market. When the Central Bank purchases Government bonds or securities, it disburses funds in the market, resulting in the expansion of the money supply. Therefore, when there is less liquidity in the market or the liquidity conditions are tight, the central bank purchases securities which releases liquidity into the market. When the central bank buys securities, it puts upward pressure on bond prices and thus, lowers interest rates. Similarly, when there is excess liquidity in the market, the Central Bank sells Government Securities which sucks excess liquidity from the system.

Regarding the concern about bond maturity, expressed in the question above, it is true that buying a bond would mean paying a certain amount upfront and then receiving a greater amount at maturity, the immediate effect, however, is most important which is injecting liquidity. Therefore, when central bank buys a security, it injects money into system but when the bond matures, the money would be taken out of circulation and to deal with this Central bank engages into continuous open market operations so that when the security / bond matures they buy new bonds to maintain the requisite level of liquidity or money supply in the system. Therefore, the immediate effect of buying securities is increase in money supply.

References:

Federal reserve Bank website:

https://www.federalreserve.gov/monetarypolicy/openmarket.htm

https://www.federalreserve.gov/monetarypolicy/bst_openmarketops.htm

Reserve Bank of India website–

https://www.rbi.org.in/commonman/English/Scripts/FAQs.aspx?Id=711#1

 

Transformations to Open market Operations,1997.  Stephen h. Axilrod, International Monetary fund, January. https://www.imf.org/external/pubs/ft/issues5/index.htm

 

Answered by:
Ph.D Student
Last updated on January 11, 2024