Open Market Operations used by Central Bank for Volume Control!
Open market operations imply deliberate direct sales and purchases of securities and bills in the market by the central bank on its own initiative to control the volume of credit.
In a broad sense, open market operations simply imply the purchase or sale by the central bank of any kind of eligible paper like government securities or any other public securities, or trade bills, etc. In practice, however, the term is applied, in most countries, to the purchase or sale of government securities (short-term as well as long-term) only by the central banks.
When the central bank sells securities in the open market, other things being equal, the cash reserves of the commercial banks decrease to the extent that they purchase these securities; by selling securities, the central bank also reduces, other thing being equal, the amount of customers’ deposits with commercial banks to the extent that these customers acquire the securities sold by the central bank.
If effect, the credit-creating base of commercial bank is reduced and hence credit contracts. In short, the open market sale of securities by the central bank leads to a contraction of credit and reduction in the quantity of money in circulation. Conversely, when the central bank purchases securities in the open market, it makes payments to the sellers by cheques drawn on itself, the sellers usually being commercial banks or customers of commercial banks.
The banker’s accounts are credited and, therefore, there is an increase in the commercial banks’ cash reserve (which is the base of credit creation) and as also an increase in the customers’ deposits with commercial banks (which is the principal constituent of money supply.)
In short, open market purchases of securities by the central bank lead to an expansion of credit made possible by strengthening the cash reserves of the banks. Thus, on account of open market operations, the quantity of money in circulation changes. This tends to bring about changes in money rates.
An increase in the supply of money through open market operations causes a downward movement in the money rates, while a decrease of money supply raises money rates. Open market operations, therefore, directly affect the loan-able resources of the banks and the rates of interest. Changes in rates of interest in turn tend to bring about the desired adjustments in the domestic level of prices, costs, production and trade.
In short, the central bank follows a policy of open market selling of securities when contraction of credit is desired, especially during a boom period when the stability of the money market is threatened by the overexpansion of credit by commercial banks. Conversely, during a depression when the money market is tight and expansion of credit is desired, the central bank follows the policy of open market buying of securities.