Open Market Operations
Open market operations are the central bank’s main day-to-day tool. Buying government securities pays banks with new reserves, which lowers the short-term rate. Selling securities drains reserves and raises it. The effect on the money supply is amplified by the multiplier.
Try it yourself
The overnight policy rate is set where reserve demandmeets the central bank’s vertical reserve supply. Demand is fenced above by the discount rate and floored just below the IORB rate. Slide supply left to move from the ample floor system into the scarce corridor.
Why it matters
The central bank does not announce a money supply, it trades to hit a target rate. By adding or removing reserves it makes overnight funds cheaper or scarcer, and the rest of the rate structure follows.
Worked examples
The central bank makes a $1 billion open market purchase. Trace the effect.
Bank reserves rise by $1 billion and the overnight rate eases. Through deposit expansion the money supply grows by a multiple of that. The simple model with a 10% reserve ratio gives a ceiling of $10 billion, but with realistic currency and excess-reserve leakages the figure is far smaller, closer to the $2.8 billion of the money-multiplier node.
Common mistakes
- ✗An open market purchase raises the money supply by exactly the amount bought. The base rises by that amount, but the multiplier amplifies the effect on the money supply.
- ✗Open market operations move long-term rates directly. They steer the short rate, and long rates respond through expectations.
Revision bullets
- •Primary tool: buying or selling government securities
- •Purchase adds reserves and lowers the short rate
- •Sale drains reserves and raises the short rate
Quick check
An open market sale of securities by the central bank
Connected topics
Sources
- Mishkin (2018), Ch. 16Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.Open market operations as the primary tool of monetary policy.