Xavier Institute of Management, Bhubaneswar

OPEN MARKET OPERATIONS

AND

EFFECT OF REPO RATES IN THEM

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Open market operations are the means of implementing monetary policy by which a
central bank controls its national money supply by buying and selling government securities,
or other financial instruments. Monetary targets, such as interest rates or exchange rates,
are used to guide this implementation.[1]

Since most money is now in the form of electronic records, rather than paper records such
as banknotes, open market operations are conducted simply by electronically increasing or
 Xavier Institute of Management, Bhubaneswar

decreasing ('crediting' or 'debiting') the amount of money that a bank has, e.g., in its
reserve account at the central bank, in exchange for a bank selling or buying a financial
instrument. Newly created money is used by the central bank to buy in the open market a
financial asset, such as government bonds, foreign currency, or gold. If the central bank sells
these assets in the open market, the amount of money that the purchasing bank holds
decreases, effectively destroying money.

The process does not literally require the immediate printing of new currency. A central
bank account for a member bank can simply be increased electronically. However this will
increase the central bank's requirement to print currency when the member bank demands
banknotes, in exchange for a decrease in its electronic balance.

Often, the percentage of the total money supply consisting of physical banknotes is very
small. In the United States only around 10% of the "M2" money supply actually exists in the
form of physical banknotes or coins. The rest exists as credits in computerized bank
accounts.

Possible targets of open market operations

1) Under inflation targeting, open market operations target a specific short term interest
rate in the debt markets. This target is changed periodically to achieve and maintain an
inflation rate within a target range. However, other variants of monetary policy also often
target interest rates: both the US Federal Reserve and the European Central Bank use
variations on interest rate targets to guide open market operations.

**Inflation targeting is an economic policy in which a central bank estimates and makes
public a projected, or "target," inflation rate and then attempts to steer actual inflation
towards the target through the use of interest rate changes and other monetary tools.

Because interest rates and the inflation rate tend to be inversely related, the likely moves of
the central bank to raise or lower interest rates become more transparent under the policy
of inflation targeting. Examples:

• if inflation appears to be above the target, the bank is likely to raise interest rates.
This usually (but not always) has the effect over time of cooling the economy and
bringing down inflation.
 Xavier Institute of Management, Bhubaneswar

• if inflation appears to be below the target, the bank is likely to lower interest rates.
This usually (again, not always) has the effect over time of accelerating the economy
and raising inflation.

Under the policy, investors know what the central bank considers the target inflation rate to
be and therefore may more easily factor in likely interest rate changes in their investment
choices. This is viewed by inflation targeters as leading to increased economic stability.

2) Besides interest rate targeting there are other possible targets of open markets
operations. A second possible target is the growth of the money supply, as was
the case in the U.S. in the late 1970s through the early 1980s under Fed
Chairman Paul Volcker.

**In economics, money supply or money stock, is the total amount of money available
in an economy at a particular point in time.[1] There are several ways to define "money", but
standard measures usually include currency in circulation and demand deposits.[2][3]

Money supply data are recorded and published, usually by the government or the central
bank of the country. Public and private-sector analysts have long monitored changes in
money supply because of its possible effects on the price level, inflation and the business
cycle.[4]

That relation between money and prices is historically associated with the quantity theory of
money. There is strong empirical evidence of a direct relation between long-term price
inflation and money-supply growth. These underlie the current reliance on monetary policy
as a means of controlling inflation.[5][6] This causal chain is however contentious, with
heterodox economists arguing that the money supply is endogenous and that the sources of
inflation must be found in the distributional structure of the economy.[

3) Under a currency board open market operations would be used to achieve and
maintain a fixed exchange rate with relation to some foreign currency.

**A fixed exchange rate, sometimes called a pegged exchange rate, is a type of
exchange rate regime wherein a currency's value is matched to the value of another single
currency or to a basket of other currencies, or to another measure of value, such as gold.
 Xavier Institute of Management, Bhubaneswar

A fixed exchange rate is usually used to stabilize the value of a currency, against the
currency it is pegged to. This makes trade and investments between the two countries
easier and more predictable, and is especially useful for small economies where external
trade forms a large part of their GDP.

It is also used as a means to control inflation. However, as the reference value rises and
falls, so does the currency pegged to it. In addition, a fixed exchange rate prevents a
government from using domestic monetary policy in order to achieve macroeconomic
stability.

Under a gold standard, notes would be convertible to gold, so there would be no open
market operations. However, open market operations could be used to keep the value of a
fiat currency constant relative to gold.

• A central bank can also use a mixture of policy settings that change depending on
circumstances. A central bank may peg its exchange rate (like a currency board) with
different levels or forms of commitment. The looser the exchange rate peg, the more
latitude the central bank has to target other variables (such as interest rates). It may
instead target a basket of foreign currencies rather than a single currency. In some
instances it is empowered to use additional means other than open market operations,
such as changes in reserve requirements or capital controls, to achieve monetary
outcomes.

Economist Robert Mundell has stated that when using open market operations it is only
possible to pursue a single target at any given time. One cannot use open market operations
to target interest rates while being on a gold standard. Likewise if you are targeting interest
rates then the exchange rates will fluctuate.

Current goals and procedures of open market operations

In the United States, as of 2006 the Fed sets an interest rate target for the Fed funds
(overnight bank reserves) market. When the actual Fed funds rate is higher than the target,
the desk will usually increase the money supply via a repo (effectively lending). When the
actual Fed funds rate is less than the target, the desk will usually decrease the money
supply via a reverse repo (effectively borrowing).
 Xavier Institute of Management, Bhubaneswar

The European Central Bank has similar mechanisms for their operations; however, it uses a
four-tiered approach with different goals: beside its main goal of steering and smoothing
Eurozone interest rates while managing the liquidity situation in the market the ECB also has
the aim of signalling the stance of monetary policy with its operations. The regular weekly
"main refinancing operations" and the monthly "longer-term refinancing operations" provide
liquidity to the financial sector, while ad-hoc "fine-tuning operations" (in the form of reverse
or outright transactions, foreign exchange swaps and the collection of fixed-term deposits)
aim to smooth interest rates caused by liquidity fluctuations in the market and "structural
operations" are used to adjust the central banks' longer-term structural positions vis-a-vis
the financial sector.

The Swiss National Bank currently targets the 3 month Swiss franc LIBOR rate, and borrows
or lends Swiss francs directly with Swiss banks (in other words, without using repos) on an
almost daily basis. These borrowings or loans are typically made for 1 day or 1 week, but
may be as long as 1 month.[citation needed]

How open market operations are conducted in the USA?

In the U.S., the Federal Reserve (Fed) most commonly uses overnight repurchase
agreements (repos) to temporarily create money, or reverse repos to temporarily destroy
money, which offset temporary changes in the level of bank reserves.[2] The Fed also makes
outright purchases and sales of securities through the System Open Market Account (SOMA)
with its manager over the Trading Desk at the New York Reserve Bank. The trade of
securities in the SOMA changes the balance of bank reserves, which also affects short term
interest rates. The SOMA manager is responsible for trades that result in a short term
interest rate near the target rate set by the Federal Open Market Committee (FOMC), or
create money by the outright purchase of securities.[3] Very rarely will it permanently
destroy money by the outright sale of securities.[citation needed]
These trades are made with a
group of about 22 (currently 17 as an immediate aftermath of 08/09 credit crisis) banks or
bond dealers who are called primary dealers.

Money is created or destroyed by changing the reserve account at a bank. The Fed has
conducted open market operations in this manner since the 1920s, through the Open Market
Desk at the Federal Reserve Bank of New York, under the direction of the Federal Open
Market Committee.
 Xavier Institute of Management, Bhubaneswar

Year Purchase Sales Net sell & purchase Total Operation

2000-2001 4471 23795 -19324 28266

2001-2002 5084 35419 -30335 40503

2002-2003 0 53780 -53780 53780

2003-2004 0 41849 -41849 41849

2004-2005 0 2899 -2899 2899

2005-2006 740 4653 -3913 5393

2006-2007 720 5845 -5125 6565

2007-2008 13510 7587 5923 21097

2008-2009 104480 9932 94548 114412

Liquidity Adjustment Facility

What does Liquidity Adjustment Facility mean?

A tool used in monetary policy that allows banks to borrow money through repurchase
agreements. This arrangement allows banks to respond to liquidity pressures and is used by
governments to assure basic stability in the financial markets.

Liquidity adjustment facilities are used to aid banks in resolving any short-term cash
shortages during periods of economic instability or from any other form of stress caused by
forces beyond their control. Various banks will use eligible securities as collateral through a
repo agreement and will use the funds to alleviate their short-term requirements, thus
remaining stable.

Liquidity Adjustment Facility (LAF) was introduced by RBI during June, 2000 in phases, to
ensure smooth transition and keeping pace with technological up gradation. On
recommendations of an RBI’s Internal Group RBI has revised the LAF scheme on March 25,
2004. Further revision has been carried wef Oct 29, 2004. The revised LAF scheme has the
following features:

Objective: The funds under LAF are used by the banks for their day-to-day mismatches in
liquidity.
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Tenor: Under the scheme, Reverse Repo auctions (for absorption of liquidity) and Repo
auctions (for injection of liquidity) are conducted on a daily basis (except Saturdays). 7-days
and 14-days Repo operations have been discontinued wef Nov 01, 2004.

Eligibility: All commercial banks (except RRBs) and PDs having current account and SGL
account with RBI.

Minimum bid Size: Rs. 5 cr and in multiple of Rs.5 cr

Eligible securities: Repos and Reverse Repos in transferable Central Govt. dated securities
and treasury bills.

Rate of Interest: The reverse repo rate will be fixed by RBI from time to time (presently
5.25%). The repo rate (presently 6.25% wef Oct 26, 2005) will continue to be linked to the
reverse repo rate and the spread between the repo rate and the reverse repo rate which
was reduced to 150 basis points with effect from March 29, 2004 has been reduced further
to 100 basis points.

Discretion to RBI: Under the revised Scheme, RBI will continue to have the discretion to
conduct overnight reverse repo or longer term reverse repo auctions at fixed rate or at
variable rates depending on market conditions and other relevant factors. RBI will also have
the discretion to change the spread between the repo rate and the reverse repo rate as and
when appropriate. (As per an IMF 1997 publication, “the sale and repurchase transactions
(reverse repo), are sales of assets by the central bank under a contract providing for their
repurchase at a specified price on a given future date; they are used to absorb liquidity”. On
the contrary, prior to above change, in the Indian context, “repo” denotes liquidity
absorption by the Reserve Bank and “reverse repo” denotes liquidity injection).

REPO RATE AND REVERSE REPO RATE

Repo (Repurchase) Rate

Repo rate is the rate at which banks borrow funds from the RBI to meet the gap between the
demand they are facing for money (loans) and how much they have on hand to lend.

If the RBI wants to make it more expensive for the banks to borrow money, it increases the
repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the
repo rate.

Reverse Repo Rate

 Xavier Institute of Management, Bhubaneswar

This is the exact opposite of repo rate. The rate at which RBI borrows money from the banks
(or banks lend money to the RBI) is termed the reverse repo rate. The RBI uses this tool
when it feels there is too
much money floating in the banking system. If the reverse repo rate is increased, it means
the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a
result, banks would prefer to keep their money with the RBI (which is absolutely risk free)
instead of lending it out (this option comes with a certain amount of risk). Consequently,
banks would have lesser funds to lend to their customers. This helps stem the flow of
excess money into the economy. Reverse repo rate signifies the rate at which the central
bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is
injected.

Bank Rate

This is the rate at which RBI lends money to other banks (or financial institutions). The bank
rate signals the central bank’s long-term outlook on interest rates. If the bank rate moves
up, long-term interest rates also tend to move up, and vice-versa. Banks make a profit by
borrowing at a lower rate and lending the same funds at a higher rate of interest. If the RBI
hikes the bank rate (this is currently 6 per cent), the
interest that a bank pays for borrowing money (banks borrow money either from each other
or from the RBI) increases. It, in turn, hikes its own lending rates to ensure it continues to
make a profit.

Call Rate

Call rate is the interest rate paid by the banks for lending and borrowing for daily fund
requirement. Since
banks need funds on a daily basis, they lend to and borrow from other banks according to
their daily or short-term requirements on a regular basis.

CRR

Also called the cash reserve ratio, refers to a portion of deposits (as cash) which banks have
to keep / maintain with the RBI. This serves two purposes. It ensures that a portion of bank
deposits is totally risk-free and secondly it enables that RBI control liquidity in the system,
and thereby, inflation by tying their hands in lending money