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Running Head: FINAL LITERATURE REVIEW
Open Market Operation
Final Literature Review
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FINAL LITERATURE REVIEW
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Open Market Operations
Introduction
Open market operations commonly written in short form as OMO is one of the ways that
the federal government uses to control the amount of money that flows in the market as well as
the interest rates of the banks. When there is a lot of money supply in the market, the Federal
Reserve sells the government securities to the bank and in the process decreasing money supply
and increasing interest rates which in turn discourages people from taking loans. On the other
hand, when there is less money supply in the market, the government buys the bonds, decreasing
interest rates increases investments which results into an increase in the money supply.
Problem statement
Money supply in an economy directly affects its investment activities. High investments
occur when there is high bank reserve, resulting into low interest rates charged by banks on the
loans. Failure to control money supply in the economy leads to it being either in excess or less.
This paper seeks to understand the role of both the federal and the bank in balancing
contractionary and expansionary monetary policies to ensure that the economy is not extremely
affected by either of the two.
Literature review
Numerous researchers have in the past carried out a study on money supply in the market
and effects of open market operation on controlling money supply. Among these studies include
one conducted by Sylvia, on open market operations focused on the various ways in which asset
pledgeability, acceptability, posting and bargaining affects liquidity of money (Rocheteau et al.
2014).
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To accomplish the aim of the research, they studied different assets under different
submarkets more favorable to such assets. Their results showed that under liquidity, open market
operations do not matter and thus insignificantly affects the economy (Rocheteau et al. 2014).
The study however focused more on short-term investments and therefore, the results may be
invalid for long-term investment plans. The extensive study conducted makes it more reliable
though and helps in understanding impact of open market operation to the economy.
In understanding the effect of liquidity in the federal funds market, Carpenter looked at
projection errors made while preparing OMO by the Federal Reserve to find out daily frequency
of the liquidity effect in the market. The findings showed that the liquidity effects were nonlinear and that big changes revealed a significant effect compared to the cases with small
changes (Carpenter, & Demiralp, 2006). The study also showed that higher bank reserve
balances results into smaller liquidity effects. The results of the study make it applicable to this
study especially in understanding the impact of open market operations on liquidity.
Another study in the same area was also conducted to determine whether open market
operations in real assets could help do away with liquidity trap (Eggertsson, & Proulx, 2016).
The study reviewed argument of no-arbitrage by Bernanke. Theoretically, the study showed that
OMO in real assets can help do away with liquidity trap because it changes incentives of
inflation. However, critical analysis using Keynesian model showed that for open market
operation in real estate to contribute in overcoming liquidity trap, it must be combined with other
measures such as fiscal policy (Eggertsson, & Proulx, 2016). This research study is relevant and
reliable since its findings were in line with the previous studies done by other people including
(Benigno, & Nistico, 2015), (Carpenter, & Demiralp, 2006), among others.
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For this study, it has opened my eyes to focus on other effects of monetary supply to the
economy as I conduct the study.
In the year 2001, Taylor carried out a study on expectations and OMO (Taylor, 2001). The
aim was to determine the extent to which open market operation accomplishes its purposes
especially in reducing unemployment. He found out that do a certain degree investments increase
with a reduction in interest rates on loans but this does not reduce unemployment (Taylor, 2001).
The targeted group which is unemployed are even more reluctant to go for the loans thus making
no difference at the end of it. He considered several factors during the study and this makes his
work reliable. This study helps me in my study to determine the various ways in which the
federal can ensure that OMO meets its purpose including reducing unemployment.
Another study conducted by (sue et al. 2015), on the impact of open market operations on
the central bank to the return rates of the stocks revealed that the impact of injection or
withdrawal to the returns of the stock market is not so clear. Other findings of the research were
that changes in bills of the central bank have a significant influence on the stock market (Taylor,
2001). His findings were consistent with those of Benigno, & Nistico, which focused on
understanding non-neutrality of open market operations (Benigno, & Nistico, 2015). To
understand these findings, I plan to look at the behavior finance theory I addition to focusing on
OMO.
And lastly Nishiyama, in his study on OMO and associated federal funds rate movement
during the week prior to the changes, found that most of the time, the federal made partial
accommodation or anti-accommodation depending on the basis points of the target (Nishiyama,
2016). This could explain their impact on market changes.
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Research Question
Do open-market operations policies ensure that the money supply in the economy is neither in
excess nor in deficit through selling and buying of government securities?
Theoretical Framework
In an open-market operation the dependent variable is the money supply because its outcome
depends on the independent variables.
The independent variables are the methods government usually uses to control money supply
which are selling or buying government securities. They determine the outcome this the
dependent variable.
An open market operation is a monitory policy tool in which the central banks buy and
sell government bonds and securities to the citizen of that country to regulate the money supply
in the economy. In the United States, it employs open market operations through the Federal
Reserve Bank. Therefore, even from the definition of the term, we can see that the central bank
has the responsibility of implementing the policy in the country. It usually carries out the plan
through the guidelines of the central government of the country.
The central bank usually sells the government bonds and securities to the open market to
regulate the amount of money supply in the country. In a situation where the sum of money in
the economy is at a high rate than what the banks own then the central bank will take the step of
selling the securities and bonds to the citizens. Through doing this, the government will reduce
liquidity supply of money in the economy.
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Hypotheses
Governments which effectively implement open-market operations policies in a timely manner
are less likely to incur problems of inflation and should be able to register steady economic
growth. Yet those which fail to implement this policy may have negative results.
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References
Benigno, P., & Nistico, S. (2015). Non-neutrality of open-market operations.
Carpenter, S., & Demiralp, S. (2006). The liquidity effect in the federal funds market: Evidence
from daily open market operations. Journal of Money, Credit and Banking, 901-920.
Cassola, N., & Koulischer, F. (2016). The collateral channel of open market operations.
Eggertsson, G. B., & Proulx, K. (2016). Bernanke's No-arbitrage Argument Revisited: Can Open
Market Operations in Real Assets Eliminate the Liquidity Trap? (No. w22243). National Bureau
of Economic Research.
Harvey, C. (1994). The Impact of the Federal Reserve Bank's Open Market Operations.
Hoag, A. J., & Hoag, J. H. (2006). Introductory economics.
Nishiyama, Y. (2016). Open market operations and associated movements of the federal funds
rate during the week prior to target changes. Journal of Economics and Finance, 1-23.
Rocheteau, G., Wright, R., & Xiao, S. X. (2014). Open market operations. Working Paper,
Wisconsin.
Su, A., Bao, W., & Bao, X. (2015, June). The impact of central bank's open-market operations to
the return rate of stocks. In Service Systems and Service Management (ICSSSM), 2015 12th
International Conference on (pp. 1-4). IEEE.
Taylor, J. B. (2001). Expectations, open market operations, and changes in the federal funds rate.
REVIEW-FEDERAL RESERVE BANK OF SAINT LOUIS, 83(4), 33-48.
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