Open market operations are the most important means of expanding and contracting money supplies in modern monetary systems regulated by central banks. Central banks, such as the Federal Reserve System in the United States, regulate money supplies as a means of maintaining economic stability and price stability.
To infuse additional money into the U.S. economy, the Federal Reserve System purchases U.S. government bonds, paying for the bonds with freshly created funds added to commercial bank deposits at any of the twelve Federal Reserve Banks. Commercial bank deposits at Federal Reserve Banks, coupled with vault cash, make up what is called “high-powered money,” because a system of commercial banks, making loans, can expand customer demand deposits by some multiple of the volume of high-powered money.
To withdraw money from circulation in the U.S. economy, the Federal Reserve system sells from its holdings of U.S. government bonds, and withdraws the proceeds of the sales from circulation and the banking system, leading to a contraction of money supplies.
The Bank of England may have been the first to regulate credit markets along the lines of modern open market operations. Late in the 19th century, the Bank of England would borrow funds in the London money market as a means of raising interest rates.
The Federal Reserve System apparently discovered by accident the practice of open market operations as an instrument of monetary control. The Federal Reserve Act of 1913 did not specifically address open market operations but did empower individual Federal Reserve Banks to buy and sell securities along the lines set forth by the rule sand regulations of the the Federal Reserve Board.
An economic slowdown in the 1920s reduced the demand for Federal Reserve Bank loans to commercial banks. Federal Reserve Banks began buying government securities in the open market as a means of acquiring incomeearning assets, compensating for the loss in the discount loan business to commercial banks. At first, individual Federal Reserve Banks separately purchased government securities, occasionally pitting
individual banks against each other in bidding for securities. The Federal Reserve Banks collectively decided to coordinate all purchases of government securities through the New York Federal Reserve Bank. In 1922, the then Federal Reserve Board, since renamed the Board of Governors of the Federal Reserve System, established a special committee, composed of board members and officials of the Federal Reserve Banks, to
make decisions about open market operations. The comparable committee is now called the Federal Open Market Committee.
The Federal Reserve Banks soon learned the impact of open market operations on money supplies, interest rates, and credit conditions, but the board remained split on the wisdom of open market operations until the 1930s. During the Great Depression of the 1930s, open market operations began to play a larger role in monetary policy. By the end of World War II, open market operations had become the most important
tool in the central bank arsenal of monetary controls.
References Anderson, Clay J. 1965. A Half-Century of Federal Reserve Policymaking, 1914–1964.
Baye, Michael R., and Dennis W. Jansen. 1995. Money, Banking, and Financial Markets: An Economics Approach.
Klein, John J. 1986. Money and the Economy, 6th ed.