Monetary Policy: Operation Twist

Monetary Policy is a macroeconomic policy, designed by the central bank of a country, RBI in India to manage money supply in an economy. It helps shaping variables such as inflation, consumption, savings, investment, capital formation etc. 

Operation twist is a newly added tool in the arsenal of monetary policy. To understand this let's first refresh the concept of bond yield through Mr. Jethalal and Ms. Babita's conversation.

Babita: Hi Jethaji, I have a government security with face value of Rs 100 which gives me 10% per annum interest, and matures in a year but I am selling it as of now will you please purchase it from me?

Jethalal: Yes sure, since you are selling I would purchase it for Rs 105.

So, here a bond's face value is Rs 100, that is returned at the end of an year with an interest of Rs 10.
Babita buys a bond at Rs 100 and if she keeps it till maturity she gets back Rs 110 while Jethalal buys the same bond at Rs 105 and if he keeps it till maturity he gets back the same Rs 110.

Bond yield for Babita is {(110-100)/100}*100 = 10%.
Bond yield for Jetha is {(110-105)/105}*100 = 4.76%. 

Yeah, so bond yield depends on purchasing price. Higher the price lower the yield and vice versa. 

Operation Twist Methodology: RBI goes to open market and sells short term (< 1 year) g-sec worth some amount X. Then it buys long term g-sec (> 10 years) worth the same amount X. 

Why does RBI buy and sell g-secs of same amount together? 

So as keep the supply of money constant in the market i.e when the central bank buys and sells the securities worth the same, the net money infused in market remains zero. What follows after is the trick, the long term g-secs come in demand since RBI buys it in large number in turn pushing the government securities price higher and we know from the conversation above that since the price moves higher the bond yield goes down. 

Why does RBI do operation twist? 

To help private companies borrow money from the market in a cheaper rate. When RBI drags the bond yield down, the investment in government security doesn't remain attractive to investors and they search for better avenues for investment which is then provided by corporate bonds issued by private sector companies. If the government yield is say 10% then investors will demand a higher interest for corporate bonds say 14% which means an expensive loan for corporate affecting the business negatively and in turn the economy especially in a downturn. If RBI drags the govt. securities' yield to 6% by purchasing bonds in huge number using operation twist, the corporate can issue bonds at 8%, a cheaper deal and can even negotiate with bank managers to get a cheap loan. Thus, helping reinvigorate business providing job growth, capital formation, increasing consumption and in turn supporting the economy.