Tools of the Central Bank: Open Market Operations

__Open market operations__ involve the purchase or sale of government securities in order to manage the money supply. These actions either increase or decrease the money supply, which can influence interest rates, economic growth, and the price level. More simply, an open market operation might involve a central bank buying bonds from a commercial bank or an individual. Imagine you are the chief executive in a central bank in some hypothetical developed economy. In an open market operation, you have purchased USD 10 million in government bonds from private individuals. Which of the following would you _most likely_ expect those individuals to do?

Correct! In doing so, those deposits would multiply via the money multiplier process. With more money in circulation, interest rates would likely fall. Lower interest rates would encourage investment and stimulate overall economic activity.

Incorrect. Such an action would leave the proceeds of the sale vulnerable to theft, loss, and erosion from inflation.

Now imagine that another open market operation is undertaken. In this case, you decide to sell USD 20 million in government securities to domestic commercial banks. Which of the following is the _most likely_ outcome here?

Correct! Since banks would observe a decrease in their reserves, they typically would curtail lending in order to maintain a level of required reserves. That curtailed lending would slow the money multiplier process and, by extension, slow overall economic activity.

Incorrect. Keep in mind that when a central bank sells government securities to commercial banks through open market operations, they do so in exchange for banks' excess reserves. That leaves banks with a lower level of excess reserves. Given fewer excess reserves, and a looming reserve requirement, banks would typically be more reluctant to make loans.

Incorrect. Unfortunately, banks do not typically have block parties.

Central banks frequently use open market operations to manage macroeconomic outcomes. In fact, central banks often engage in the sale and purchase of government securities on a daily or weekly basis in order to manage the money supply or to keep interest rates within specified target ranges. With that in mind, which of the following statements is _most accurate_?

Incorrect. The sale of government securities—to either individuals or banks—would lower reserves, causing bank lending to slow. That would slow the money creation process and also discourage economic growth.

Incorrect. If bonds were purchased from banks, banks would have excess reserves and typically would lend those reserves out. If bonds were purchased from individuals, those proceeds would be deposited in banks, which would also increase banks' reserves and result in a greater number of loans. Either way, excess reserves would grow, more loans would be made, and the money supply would increase.

Correct! In doing so, inflationary pressures may be mitigated. It is for this reason that a central bank may engage in this type of open market operation.

In summary: [[summary]]

Place the proceeds of that sale in the bank

Put the money received from the sale of bonds in a cookie jar

With a reduction of USD 20 million in reserves, banks would determine that they could no longer make as many loans as previously anticipated

Commercial banks would find that their reserves had increased

Commercial banks would have a seriously large block party

In order to increase the money supply and lower interest rates, a central bank would sell bonds

A central bank’s purchase of bonds would decrease the money supply and drive interest rates higher

Open market operations, where a central bank sells bonds, would lower the money supply and increase interest rates

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