Open market operations (OMOs) are a primary tool used by central banks, like the Federal Reserve in the United States, to regulate the money supply and influence interest rates. Here’s how they work and their impact:

Impact on Money Supply:

1. Buying Government Securities:
• When the central bank buys government securities from the market, it pays for these securities with new money. This increases the reserves of the commercial banks, allowing them to create more money through lending. Consequently, the money supply in the economy increases.
2. Selling Government Securities:
• When the central bank sells government securities, the buyers pay with their bank reserves. This reduces the reserves available in the banking system, thereby reducing the money supply.

Impact on Interest Rates:

1. Lowering Interest Rates:
• When the central bank buys government securities, the increased money supply leads to lower interest rates. This happens because banks have more reserves and can lend more easily, leading to a decrease in the cost of borrowing.
2. Raising Interest Rates:
• Conversely, when the central bank sells government securities, the reduced money supply leads to higher interest rates. With fewer reserves, banks lend less, and the cost of borrowing increases.

Summary

• Buying securities (OMO expansionary): Increases money supply, lowers interest rates.
• Selling securities (OMO contractionary): Decreases money supply, raises interest rates.

Through these operations, central banks aim to manage economic activity, control inflation, and maintain financial stability.