A central bank is the apex institution of the monetary and banking structure of the country.
It performs several important monetary functions in the banking system.
According to A.C.L. Day a central bank ” helps and controls and stabilizes the monetary and banking system .“
Along with several other essential functions, the central bank ‘s most important function is to control the credit creation power of commercial banks .
“Central Bank also known as Controller of Credit “
Credit control is the means to control the lending policy of commercial banks by the Central Bank .
The central bank controls credits in accordance with the needs of business and with a view to carrying out the broad monetary policy adopted by the state.
It adopted two methods of credit control :-
• Quantitative Credit Control Methods
• Qualitative Credit Control Methods
Open market is one of the methods of quantitative credit control used by the central bank .
What is open market Operations ( OMO ) ?
Open market Operations in general terms means dealing with government securities and bonds.
To elaborate more, Open Market Operations refers to the sale and purchase of securities , bills and bonds of government as well as private financial institutions by the Central Bank .
OMO is an activity by a central bank to give or take liquidity in its currency to or from a bank or a group of banks.
There are two principle motives of open market Operations
• to influence the reserves of commercial bank in order to control power of credit creation
• to affect the market rates of interest and supply of base money
In order to manipulate the short-term interest rate and the supply of base money in an economy, i.e to indirectly control the total money supply, the central bank buys and sells government securities, or other financial instruments.
Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.
In the given figure , S is the supply curve of bank money which shifts to the left as S¹ showing a decrease in the supply of bank money from B to A , given the level of interest rate r .
When the central bank aims at an expansionary policy during a recessionary period , it purchases government securities from the commercial banks and institutions dealing with such securities .
The supply curve of bank money shifts from S¹ to S², showing an increase in the supply of bank money from B to C .
The bank will now lend more at the given rate of interest r.
As the result of change in supply of bank money in market through the open market operations
The market rates of interest also change .
A decrease in the supply of bank money through sale of securities will raise the interest market rates and an increase in supply of bank money will reduce the market rate interest. ___________________________________________
Open Market Operation policy in India
The fact that India is a developing country its capital flows are very different from those in developed countries which influence the Open Market Operation policy .
India’s central bank, the Reserve Bank of India (RBI), has to make policies and use instruments accordingly. RBI’s major source of funding and control over credit and interest rates was the cash reserve ratio (CRR) and the SLR (Statutory Liquidity Ratio). But after the reforms, the use of CRR as an effective tool was deemphasized and the use of open market operations increased. OMOs are more effective in adjusting.
RBI use two types of OMOs :-
Outright purchase (PEMO):
It is outright buying or selling of government securities.
Repurchase agreement (REPO):
It is short term, and is subject to repurchase.
OMOs are the most effective credit control instrument with the central bank and are preferred over other methods.
Limitations of Open Market Operations
Although being an effective method OMO has certain limitations such as :-
• Lack of Securities Market :-. It is important to have an organised security market system for central banks to buy or purchase securities on a large scale.
• Unstable Cash Reserve Ratio:- The buying and selling of securities and bonds by central banks highly influence the cash reserve ratio which is to be maintained at a fixed rate .
• Penal Bank Rate : – According to Profs Aschheim penal rate is one the necessary conditions for success of open market operations. If the penal bank Rate of discount is higher than the market rates of interest , the commercial bank can not increase their borrowings.
• Pessimistic and Optimistic Attitude :- The pessimistic and optimistic attitude of the business community also limits the operations of open market policy. A business may be unwilling to take the risk of taking out a loan during a depression .
• Velocity of Credit and Money not Constant :- The velocity of credit increases during periods of brisk business activities and decreases in periods of falling prices. Hence ,the unstableness of velocity of credit and money constantly affects open market operations.
Despite the given limitations , the central banks find the Open Market Operations instrument the most successful for controlling credit in developed as well as developing countries.
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