Open Market Operations

Open Market Operations

The Central bank enters in to the bond market and purchases or sells government securities for bringing about expansion or contraction of credit. Open Market sales bring about contraction of credit in the following way

RBI sells bonds worth rs: 5 crore. They are purchased by a person A. he gives a cheque for Rs. 5 Crore to the RBI. This cheque is drawn upon some commercial bank (BOB). RBI collects the amount from BOB. The cash in the possession of BOB is reduced by Rs 5 cr. It has to reduce credit to the extent of a multiple of rs : 5 cr. If the ratrio of cash held by the commercial banks to their deposits is 10%, a draining of 5 crore from the cash reserves of the commercial banks can bring about a contraction of credit to the extent of Rs. 50 cr.

When the Central bank wants to bring about expansion of credit, it purchases govt bonds in the open market. It gives cheques drawn upon itself to the sellers of those bonds. They deposit those cheques with the commercial banks in which they have their accounts. The amount of these cheques are collected by the commercial banks from the central bank. The cash reserves held by the commercial banks increase. They are able to expand credit  to the multiple of the additional cash reserves.

The ephicacy of the open market operations depends upon the following factors:

a)    An adequate volume of government securities in the market

The central bank can purchase a sizeable amount of government securities provided the total volume of government securities in the market is large.

b)    The capacity of the central bank to invest in government bonds

The central bank is described as the Lender of the Last Resort. It has to maintain a very high degree of liquidity. The government bonds may be absolutely safe but the central bank may find it difficult to convert them into cash in an emergency.

c)    A very big sale of bonds in the market may result into a substantial fall in bond prices that may be harmful to their prices in particular and the entire capital market in general.

As between bank rate and open market operations the OMO are more effective. The central bank takes initiatives in implementing the open market operations. In the bank rate the role of the central bank is a little passive. if the commercial banks have excess liquidity they may not raise the market rate even though the central bank raises the bank rate. In that situation the central bank starts open market sales, takes away excess liquidity from the commercial banks and then raises the bank rate. Now the commercial banks are forced to approach the central bank for accommodation. If the bank rate is increased in that situation, the commercial banks have to pay a higher rate. They are forced to raise their rate of interest. Thus the bank rate and the OMO are often used simultaneously.