If you want to learn how to invest, the open market is probably not the first thing you should study, however it is beneficial to understand what it is and how it works. Open market refers to the environment in which bonds are bought and sold. A central bank may enter this market to buy or sell government bonds to increase reserves. This investment philosophy is known as open market operations. How this works is the central bank buys bonds from local banks in exchange for checks. The local banks then cash the checks enabling them to get money from the central bank. By cashing the checks the local banks decrease any credit owed to the central banks, resulting in an increased money supply, which in turn, increases their reserves. This operation is the Federal Reserve’s primary method for implementing monetary policy and is includes the purchasing and selling of the U.S Treasury and federal agency securities. While this is the primary method, it is not the only method available to the Federal Reserve. Other methods used include adjusting reserve requirement ratios and changing the terms and conditions for borrowing at the discount window. This is again, the primary method since it is the most flexible method the Federal Reserve has for carrying out its objectives. Under a currency board open market operations would be used to attain and preserve a fixed exchange rate with relation to some foreign currency. It is helpful to understand this concept if you are looking into foreign stocks so that you may begin conducting foreign currency trading.
The Federal Open Market Committee
This committee is responsible for the open market operations and its short-term goals are defined by this committee as well. The goals and objectives defined by this committee have changed throughout the years. In recent years, the committee typically assesses the risks associated with the attainment of its goal for price stability and sustainable economic growth. In past years, however, the focus has been to attain a specific level of the federal funds rate. This rate is the interest rate for which depository institutions lend balances at the Federal Reserve to other depository institutions over night. Under a gold standard these operations would be used to achieve and maintain a target gold price. The goal would be to keep the value of the currency constant relative to gold. This is an important concept to understand if you are interested in gold investing.
Open market operations are conducted by electronically increasing or decreasing the amount of money that a bank has. The newly created money is then used by the central bank to buy in this market. If the central bank sells its assets in the open market the money can be destroyed since the amount of money that the purchasing bank holds, actually decreases. This does not necessarily mean that there is a need to print new currency, but that the central bank account should be increased electronically. This will increase the need for the central bank to print currency in exchange for a decrease in its electronic balance. This form of money management conducted by banks is lucrative to the success of market operations.
The Federal Reserve conducts open market operations using a core group of dealers. These dealers are government securities dealers that have an establish trading and investing relationship with the Federal Reserve. The Federal Reserve operates in the collateralized lending market with this core group of dealers who have accounts at clearing banks. This system works because this core group of dealers will work through the use of the clearing banks, which are depository institutions. As a result, the Federal Reserve sends and receives funds from these accounts at the clearing bank, which adds or drains reserves to the banking system thus conducting open market transactions. It is helpful to understand the investment basics when reading on this topic.