What is an Open Market?
An open market is an economic system with no trade barriers to free market activities. In an open market, buyers and sellers can do business freely without common market barriers, such as unfair licensing agreements, arbitrary taxes, unionization, subsidies, and other regulations that affect regular market operations.
- An open market is a market with no regulatory barriers, such as taxes, licensing requirements, and government subsidies.
- An open market allows buyers and sellers to trade freely without any external market.
- The prices for goods and services are determined by the shifts in supply and demand.
Understanding the Open Market System
The level of openness of the open market is judged by the amount of government regulations and the presence of cultural customs that affect trade. Generally, an open market allows a level playing field for all market players, and there are no external constraints that affect free trade activities.
The economic actors enjoy an equal opportunity of entry in an open market, unlike in a closed market, where a few large companies dominate the market. Also, in a closed market, entry is subject to tariffs, taxes, or state subsidies that prevent some economic actors from freely participating in the market.
In banking, the term “open market” may be used to refer to the environment in which the Federal Reserve buys or sells bonds from member banks as a way of raising or lowering interest rates. The intervention by the Fed or central banks is known as open market operations, and it involves trading in Treasury notes or mortgage-backed securities to raise reserves.
For example, when the Federal Reserve wants to raise interest rates, it sells Treasury bonds to member banks with the goal of slowing down inflation. It is a contractionary monetary policy that aims at stabilizing economic growth. The opposite is the expansionary monetary policy, where the Fed buys bonds from its member banks as a way of lowering the interest rates. The Fed pays for the bonds using checks, which when cashed, moves money from the government agency to the bank reserves of the regulated banks.
Open Market vs. Closed Market
An open market is considered more accessible to participants compared to a closed market. The United States, the United Kingdom, Canada, and Australia are seen as relatively open markets where buyers and sellers can trade without any regulatory barriers. The prices of goods and services in these markets are determined by the shifts in supply and demand, and there is minimal interference by government entities in setting prices.
However, there is no completely open market that exists in the world. Large established companies may create barriers to entry to make it difficult for new and smaller companies to access the market. Nevertheless, there are no regulatory hurdles that may prevent smaller companies from getting a share of the market.
On the other hand, closed markets do not provide a level playing ground for all economic actors, and they tend to adopt prohibitive regulations that constrain free trade activities. Countries such as North Korea and Cuba are relatively closed markets, with various regulatory barriers that aim to protect domestic trade from unfair competition by large foreign companies.
The regulatory barriers may take the forms of pricing or participation restrictions. Pricing restrictions occur when the prices of products and services are determined by other methods other than the shifts in supply and demand. Participation restrictions are laws that regulate who can participate and who cannot participate in the market. For example, some countries may require foreign companies to local owners to take on a certain percentage of ownership before they can be allowed to trade in the country.
How the Open Market Affects Interest Rates
The Federal Reserve buys and sells government bonds in the open market, an activity known as open market operations. The Federal Open Market Committee (FOMC) is charged with overseeing open market operations. The activities are undertaken with the aim of increasing the money supply in the hands of consumers, who use the funds to invest and stimulate economic growth.
Where the interest rate for credit is high, the Fed buys government bonds from its member banks. The Fed pays for the securities using cheques or electronic transactions, which increases the bank’s reserves. Banks are required to retain at least 10% of their deposit in reserve, and the funds must be kept at the bank’s vault or at the local Federal Reserve branch office. The reserve helps cover the bank’s daily withdrawals.
If a bank’s reserve falls below the reserve requirement, it borrows from other banks at a special interest rate known as the federal funds rate. When the Fed buys securities from member banks, it increases the reserves and also makes more Fed funds available to lend to other banks.
The increase in money supply lowers the Fed funds rate, and it, in turn, lowers the interest rates on other financial investments in the economy. A lower Fed funds rate makes it cheaper for consumers and borrowers to borrow money, helping stimulating economic growth.
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