Open Market Operations

The mechanics are a balance-sheet exchange. When the central bank buys a Treasury security from a primary dealer, the security appears on the asset side of the central bank's balance sheet and a matching credit appears on the liability side as reserves held by the dealer's clearing bank. No existing money is consumed: the central bank creates the settlement balance by keystroke, which is why the operation expands, rather than drains, the system's stock of reserves. A sale reverses the entries, extinguishing reserves as the buyer's account is debited.

Operations come in two forms. Outright transactions permanently add or remove securities. Temporary operations use repurchase agreements, in which the central bank buys securities with an agreement to resell in days or weeks, adding reserves only for the life of the contract; reverse repos drain reserves temporarily. Temporary operations are the everyday tool for smoothing frictions such as tax dates and quarter-end funding pressure.

Banks trade reserves overnight in an interbank market. When the central bank adds reserves, the marginal bank that would have borrowed no longer needs to, bidding for funds falls, and the overnight rate drifts toward the bottom of the operating range. Draining reserves has the opposite effect. In a scarce-reserve corridor system, small daily operations are enough to keep the overnight rate near target, because the demand curve for reserves is steep at the relevant quantity.

Under an ample-reserve or floor system the overnight rate is anchored instead by administered rates, chiefly the rate paid on reserve balances and an overnight reverse repo facility, with the balance sheet set to keep supply on the flat portion of the demand curve. The direction of effect is unchanged, but the mechanism shifts from quantity fine-tuning to arbitrage against the administered floor. The onward transmission runs to short-term credit spreads, bank lending, longer yields through expectations, the exchange rate and finally output and inflation, with lags.

Open market operations are visible in the weekly statement of a central bank's condition: securities held outright, repurchase agreements, and on the liability side reserve balances, currency and government deposits. Growth in the securities portfolio alongside growth in reserves is the signature of easing; runoff of maturing holdings without reinvestment is passive tightening.

For the commercial banking system, added reserves create the raw material for deposit creation. In the simple textbook framework, the potential expansion of broad money equals the injection divided by the reserve requirement, so an injection with a ten percent requirement supports up to ten times that amount in deposits. Candidates should treat that multiplier as an upper bound rather than a forecast: excess reserve demand, capital constraints, weak loan demand and cash leakage all reduce realised money growth, which is why large post-crisis injections coincided with modest broad money expansion.

Three competencies recur. First, direction: link a purchase to more reserves, lower short rates, easier credit and, other things equal, a weaker domestic currency, and a sale to the reverse. Second, classification: distinguish open market operations from the other conventional levers, namely the policy or discount lending rate and reserve requirements, and recognise that most modern central banks lean on open market operations plus administered rates because they are continuous, reversible and market-priced.

Third, limits. Open market operations lose traction when nominal rates reach the effective lower bound, when banks hoard reserves rather than lend, or when the constraint is solvency rather than liquidity. That is the entry point for unconventional policy: large-scale asset purchases, maturity extension and forward guidance. You should also be able to explain sterilised intervention, in which a central bank offsets the reserve impact of a foreign exchange operation with a domestic open market transaction so the policy rate is left undisturbed.