Method 2: Open Market Operations in the Domestic Money Market

Assume that the Thai currency is pegged to the USD, and speculators are speculating on the Baht. As the Governor of the BOT, you decided to protect the Baht by affecting the interest rates in the domestic money market market, through open market operations.

Use the sliding bar in Figure 2 below to simulate the transmission of an open market operation (either to buy more government bonds, or to sell more government bonds.

  • Explain the effects of the open market operation on the quantity supply of money, interest rates and exchange rates.
  • Explain the impact of BOT's open market operations on the quantity supply of money(Baht) in the domestic money market, the interest rates and the value of the Baht vs USD in the foreign exchange market.

Figure 2

Instructions

  • Top Chart: the relationship between interest rates and the value of the Baht vs USD in the foreign exchange market.
  • Bottom Chart: Captures the relationship between interest rates and the supply of Baht in the domestic money market.
  • Moving the sliding bar to the right simluates the effect of buying more government bonds.
  • Moving the sliding bar to the left simluates the effect of selling more government bonds.
 
Current
Values
(Millions)
New
Values
(Millions)
Money Supply
{{demoScenario.vars.currentMs | number:0 }}
{{demoScenario.vars.targetMs | number:0 }}
*Money Supply = NDA + NFA
Current Exchange Rate

{{demoScenario.vars.currentFx | number:3 }}

New Exchange Rate

{{demoScenario.vars.targetFx | number:3 }}

Current Money Market Interest Rate

{{demoScenario.vars.currentInterestRate | number:2 }}%

New Money Market Interest Rate

{{demoScenario.vars.interestRate | number:2 }}%

Sell More
Govt. Bonds
Buy More
Govt. Bonds

Explanation

  • The quantity supply of money can be changed via Open Market Operations:

    • To decrease liquidity in the domestic money market and hence reduce the quantity supply of money, the BOT sells government bonds.
    • To increase liquidity in the domestic money market and hence increase the quantity supply of money. the BOT buys government bonds.
  • A decrease in Money Supply raises the cost of borrowing, r and thus dampens the economy. The higher rate of return on the currency makes the currency more attractive and causes fund managers to reposition their international portfolio by increasing the demand for the currency and the currency appreciates.
  • An increase in Money Supply pushes down the cost of borrowing, r and thus stimulates the economy. The lower rate of return on the currency makes the currency less attractive and causes fund managers to reposition their international portfolio by reducing the demand for the currency and the currency depreciates.
  • Summary: The open market operations has effects not only on interest rates but the exchange rates as well.

Next: Activity 2 - Case Study, The Asian Financial Crisis in Thailand

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