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Economics/Why Open Market Operations can control the money supply


QUESTION: Hi Warren,

I understand that in order to increase money supply, a central bank will buy bonds from the market. To reduce the supply of money, the central bank will sell bonds to the market.

So, in times of financial crises and the central bank decides to increase the supply of money, I can see why the market e.g. commercial banks will be selling their bonds to the central bank in exchange for money.

However, suppose later that the central bank decides to reduce the money supply i.e. sell its bonds to the market. Who is going to buy them and what is their motivation to buy? If its the same commercial banks again, why would they want to buy it back? I guess they would buy it if the central bank sells to them at a lower price than when they sold it to the central bank earlier but this implies that the central bank is going to make a loss on all of their open market operations.

ANSWER: Hi, Sara--

In this era of 'QE'--'quantitative easing,' as it's called--that's a great question. Sorry it's taken me a while to respond. We've been traveling.

The primary buyers of a central bank's bonds are commercial banks. Banks seek (a) liquidity, (b) safety, and (c) certainty in the 'duration' (length) of their investments and loans to borrowers. They want to match the duration of their assets with the duration of their liabilities. This is called asset-liability management.

Commercial banks are not in the 'trading business.' They don't buy and sell bonds to make money on changes in bond prices. They buy and sell bonds for the three reasons I listed above.

Central banks don't care if they make a profit or take a loss on their open-market operations. That's not the business they're in. They don't have tax returns or shareholders, nor do they have to disclose--yet--the results of their open-market activities. They aim to control inflation (through open-market transactions) and provide liquidity to economies.

Please do me the favor of replying to the e-mail you'll receive on the heels of this reply. Your ratings and, especially, your written comments help me do a better job of helping folks like you who ask such interesting questions! And a Merry Christmas to you in Singapore, Sara.


---------- FOLLOW-UP ----------

QUESTION: Hi Warren,

Thank you very much for your insightful answer. I just have some points I would like to seek clarification on:

Is it possible that the central bank may not be able to find buyers for its bonds? I would imagine no commercial banks would want to buy it if their asset-liability management policy does not dictate it. Has such a case happened before?

Glad to help, Sara.

Selling something is a simple matter of price. The only way a central bank could find no buyers for its bonds would be if markets seized up as they did in September 2008. In that case, the central bank wouldn't be selling bonds. It would be buying them and providing liquidity to markets.

I'm not a historian of central banking, so I cannot answer the rest of your question. But I have my doubts that the scenario you describe has ever happened because different banks have different approaches to asset-liability management.

Hope this helps.


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Warren D. Miller, CFA, CPA, ASA


My expertise in economics is limited to three sub-disciplines: Austrian economics, industrial organization, and evolutionary economics. Questions dealing with macroeconomics and other sub-disciplines of the subject should be submitted to those who have the appropriate expertise. N.B.: I DO NOT ANSWER QUESTIONS MARKED 'PRIVATE' because I believe that knowledge should not be hoarded. I also believe that such questions are likely to come those trying to cheat. Also, as one who was a full-time academic for half a decade, I can recognize test/homework questions several time zones away. Do not demean yourself by submitting such questions to me. Those who do so are cheating; I WILL call you out publicly. I have a zero-tolerance policy for cheating and dishonesty. In addition, please don't emulate the businessman who posted a request for help in August 2008. He expressly denied that he was seeking "investment advice" and said that his query was for, and I quote, "educational and informational purposes." Later, he allowed as how his questions related to the possible purchase of a $500K piece of equipment. I said I thought he had misrepresented himself. Bottom line: high-end business consulting is how I make my living. I am the sole support for my family. Please respect that fact and don't try to get for free what our clients pay for. If your company is big enough to have a sophisticated problem, it can afford to pay for the expert advice we and others provide. Beckmill Research, LLC, is a 95-octane firm. We're small, but we've been at this for nearly 20 years. We know what we're doing. Segue: Early on, some asked me for career advice; I gave it. I now get many such requests. The demand for a valuable good that is free is unlimited, so I now charge for that advice. Email me: Finally, PLEASE DO NOT ASK FOR INVESTMENT ADVICE. I am not licensed to provide such advice. If you want such counsel, talk to your financial planner or other financial adviser.


I work with Austrian economics (which differs in major respects from the traditional economics), industrial organization (which is about industry structure, conduct, and performance), and evolutionary economics (almost, but not quite, the economic analog of its biological counterpart) every day in my work. I appraise closely-held businesses, provide exit-planning services, and offer high-level strategic analysis, advice, and solutions to CEOs and owners of mid-sized businesses. Understanding, applying, and writing about these disciplines is an essential part of how I have made my living since 1993.

CFA Institute, Strategic Management Society, American Society of Appraisers, Academy of Management, Culver Legion, National Association of Scholars.

CFA Magazine, Strategic Finance, Valuation Strategies, Journal of Advanced Property Economics, Harvard Business Review, American Fly Fisher, CFA Digest, CPA Expert, Business Valuation Review, among others

Chartered Financial Analyst designation (2006); Accredited Senior Appraiser in Business Valuation (2006); Certified Public Accountant (1992); MBA - Oklahoma State University (1991); Completed all of my Ph.D. coursework in strategic management - Oklahoma State University (1983-87); BBA in finance and accounting - U. of Oklahoma (1975)

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Business Valuation Volunteer of the Year (2001) - American Institute of CPAs; Winner - Oklahoma Humorous-Speaking Contest - Toastmasters International (1971)

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