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An open market operation or OMO is a macroeconomic activity in which a central bank provides liquidity in its monetary system to a bank or group of banks. The reserve bank could either purchase or sell government securities or other financial assets in the open market, which is now mainly a preferred solution, to gain entry into a repo or safe and secure lending transaction with the commercial bank. The central bank lends money as a deposit for a set period and simultaneously takes an eligible property as collateral.

About OMO

OMO is typically used by central banks as a means of achieving monetary policy. But apart from supplying financial firms with liquidity or sometimes taking beneficiaries from commercial banks, the usual goal of open market operations is to modify the short-term rate of interest and replenish base money in the economy. This entails buying and selling sovereign bonds or other financial products to meet the demand for base money at the target interest rate. Monetary targets such as rising prices, interest rates, and currency exchange rates are being used to lead this application.

Types of Open Market Operations

In short, the Federal Reserve Board of Governors establishes a target federal funds rate, and the Federal Open Market Committee enforces open market operations and achieves that rate. 

OMOs are classified into two types: 

Permanent open market operations (POMO) 

It relates to the Central Bank or any central bank’s use of the open market to purchase and sell securities to correct the money supply on a continuous basis. POMO has been one of the Federal Reserve’s tools for implementing monetary policy and influencing the American economy.

Short-term open market operations (SOMO)

They are being used to add or deplete reserves available to the banking system, addressing reserve requirements that are deemed transitory in nature. These operations either are repurchase agreements or reverse repurchase agreements, as opposed to POMOs, that also involve absolute purchases or sales. This means that the Central Bank enters into the transaction with the intention of doing the opposite in the future—buying back if it sells or reselling if it buys.

Working of Open Markets Operation

The Central Bank can impact market conditions and thus the economy by trading. When the Central Bank wants to raise interest rates, it sells securities to the banks. This is referred to as contractionary monetary policy. Its implementation is aimed at slowing inflation and stabilising economic growth.

In addition, when the Central Bank needs interest rates to rise, it purchases securities. This is an expansionary monetary policy aimed at stimulating growth.

The Central Bank adds credit to a bank’s reserves when it purchases government securities from it. Despite the fact that it is not actual money, it is treated as such, which has the same impact. It’s equivalent to a direct deposit from your employer into your checking account. This allows the bank to lend more money to the consumers, who could then devote it freely.

Banks attempt to lend more than they can in order to increase profits. Banks would lend it all if they could. The Fed, on the other hand, requires banks to hold a fraction of their funds in reserve when they close each night in order to have enough money on hand for the next transactions.

Interest Rates Influenced by Open-Market Operations

Whenever the Central Bank expands a bank’s money by purchasing its securities, the bank receives extra Central Bank funds from various offers to other banks. As the financial institution tries to offload this extra reserve, the feds fund rate falls. Banks would then raise the federal funds rate whenever there was less money to lend.

These Central Bank funds have an impact on short-term rates of interest. Banks will charge each other a slightly higher interest rate for longer-term loans. It is referred to as the London Interbank Offered Rate (LIBOR). It serves as the foundation for the majority of variable rate loans, such as car loans, extendable mortgages, and monthly interest rates. 

Conclusion

The Federal Reserve manipulates interest rates through open-market operations. The Central Bank raises and falls the supply of securities by buying or selling them, affecting demand and thus pushing interest rates up or down. The Central Bank uses open-market operations as one of its tools to boost economic activity. Adjusting the federal funds rate, as well as the reserves required for the banks, are two other tools.