A Business Encyclopedia

Open Market Operations

Definition: The Open Market Operations refers to the sale and purchase  of government securities and treasury bills by the central bank of the country with a view to regulate the supply of money in the economy.

When the central bank wants to increase the money supply in the economy, it purchases the government securities, i.e., bills, and bonds. On the other hand, the central bank sells the government bonds and securities if the money supply is to be curtailed. The open market operations are one of the most widely used measures of monetary control.

The central bank carries out its open market operations through the commercial banks, i.e. it does not deal directly with the public. The major buyers of government bonds comprise of commercial banks, financial institutions, big business corporations, and individuals with high savings. These buyers hold their respective accounts in the banks and on the purchase of the government bonds the money gets transferred to the RBI account.

Thus, the open market operations affect the bank’s deposits and reserves and their ability to create credit. For example, when the central bank plans to reduce the money supply and the availability of credit to the public, will offer the government bonds and securities for sale through the commercial banks.  The sale of government securities will affect both the supply of and demand for credit.

As regard the supply of credit gets adversely affected in the following ways:

  • The buyers of government bonds and securities often pay through a cheque drawn on the commercial bank in the favor of the central bank. Thus, at the time of a sale of government security, the money is transferred from the buyer’s account to the central bank account. This reduces the deposits and reserves of the commercial banks. Due to which the credit creation capacity of the commercial bank reduces. As a consequence, the flow of credit to the society from the commercial bank also reduces.
  • When the commercial bank buys the government bonds and securities themselves, their cash reserves reduces. This further reduces their credit creation capacity and as a result, the flow of credit to the society further reduces.

As regards the demand for credit, when the central bank sells the government bond and securities, their prices go down, and the rate of interest goes up. As a result, there is an upward shift in the interest rate structure. With an increased rate of interest the demand for credit decreases. Thus, the open market operations affect not only the supply of but also the demand for credit.

On the other hand, if the central bank decides to increase the money supply will buy back the government securities, then the money will flow out from the central bank account to the people’s account with the commercial banks. As a consequence, the deposits and the reserves of the commercial banks increases. This enhances their credit capacity and as a result, the flow of credit from the banks to the public also increases.

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