Even though it is considered a principal tool of the monetary policy, not many people can claim of knowing what open market operation actually means. It is basically the process of implementing a monetary policy by which the central bank controls the total money supply by controlling the term interest rate and supply of base money within the economy.
Though the concept is more or less same in all the economies, you may see some difference in the methods in which it is carried out. Similarly, the objectives of the same may differ from one economy to another.
What is Open Market Operation (OMO)?
It's a process in which government securities are either purchased in the open market to expand the amount of money, or sold to contract it. When it comes to the US economy, it can be put as trading of government securities in the open market. While the purchase of these securities facilitates growth in the economy, their sale does the exact opposite.
This buying and selling of securities helps in stabilizing the economy. During an inflation, when too much of money in the market affects the value of a dollar, sale of securities helps in taking out the money from the economy and stabilizing it.
The targets used in the implementation of OMOs include inflation, interest rates, exchange rates, etc. The targets of these operations differ from one section to another. Its most important goals include attaining a specific short-term interest rate in the debt markets, growth of money supply, achieving and maintaining a fixed exchange rate, etc.
How it Works in the United States?
In the US economy, the Federal Reserve System―the central bank of the US (also known as Fed), is responsible for formulation and implementation of monetary policies. Within the Federal Reserve System, there is the Federal Open Market Committee (FOMC), which is supposed to monitor the policy making process of the open market operations.
When the Federal Reserve buys securities from a particular dealer, the payment is done by crediting the reserve account of the dealer's bank at the Federal Reserve Bank. When Federal Reserve sells securities to a particular dealer, the payment by the dealer helps in reducing reserves of the dealer's bank as well as the monetary system.
Similarly, in the Eurozone, the European Central Bank resorts to this concept to stabilize interest rates and manage liquidity in the market. In Europe though, it is a four-tier system, which has certain steps that are executed at specific intervals.
In the US, the most important duty of the Fed is to stabilize the economy by managing nation's money supply. For this, they use 3 tools of monetary policy; open market operation, discount window borrowing, and reserve requirements. To maintain stability in the economy, the monetary policy has to be elastic, and these three tools ensure that it stays elastic.