Open Market Operations

The Theory. Thc term Operations’ in the wider sense means purchase or sale by a central bank of any kind of paper in which it deals, like government securities or any other public securities 01 trade bills, etc. In practice, however, the term is applied to purchase or sale of government securities, short-term as well as longterm. at the initiative of the central bank, a a deliberate credit policy. This method of credit control has attained great im rtance during thc last two or three decade .

The tit ry of open market operation.: The sale of securities by the central b. nk leads to contraction of credit . nd the purchase thereof to credit when the central bank sell ccurrucs in the open market, It  pay ment 111 the form of a cheque 0 on of the COI1lmcrcial hank. If the purchas cr is a  bank, the cheque is dr n a’ in t the purchasing hank. III both c the result is the same, The cash balance of the ban in question. which it  keeps with the central bank. i to that extent reduced. With the reduction of its cash, the commercial bank has to reduce its lending. credit contracts. When the central hank purchases securities, It pnys through cheques drawn on itself. Thi: incrca c the cash balance  of the commercial hanks and nablc: them to expand credit, “Take care or the legal tender 1I10ncy and credit Will take care of itself’ is the maXII1I.  This method is sometimes adopted to make the bank rate policy effective. If the member-banks do not raise thcir rates following the rise in the bank  rate, due to surplus fUl’lds available with the 111, the central bank can withdraw such surplus funds by the sale of securities and thus compel the member-banks  to raise their rates. Scarcity of funds in the market compels the banks directly or indirectly to borrow from the central bank through rediscounting bills. If the bank rate is high. the market rate cannot remain low. LilllilatiulI’ of the ‘I’hcur-y. It is obvious that  the above will be valid only If certain condiuons arc satisfied. The hmitunons arc discussed below: (i) The theory is that when the central bank purchases securities, the cash re: crves of the memberbanks will be increased and conversely, the cash reserves will be decreased when the central bank sells securities. This, however, may not happen. The sale of securities may he offset by inflow of gold into the bank or b) return of notes from circulation and hoards. The purchase of securities, on the other hand, may be accompanied by an outflow of gold or withdrawal of notes fur increased currency requirements or for hourding. In both the cases, therefore, the cash reserves of the member-banks may rc m nm unaffected.

(iil But c en if the ca It reserves of the I11CI11 bcr-banks ar 111rea cd r d creased, the banks may not ell. and r contra 1 credit accordingly, The pel ccntage of cash III credit is not rigidly hxcd and can vary within quite widr; limits. The banks will c: pand and contract credit acconhng to the prcvaihng ceo nomic and political circumstances and not merely with reference to their cash resources. (iii) The third condition is that when the commercial banks’s cash resources increase the demand for 10at!Sand advances should increase too, and vice versa. This may not happen. Owing to economic or political uncertainty, even cheap money rates may not attract borrowers. Conversely, when trade is good and prospects of profits brjght, entrepreneurs would borrow when at high rates of interest. (ii) Finally, the circulation of bank credit should have a constant velocity. But the velocity of bank deposits is rarely constant. It increases in periods of rising business activity and decreases in periods of depression. Thus, a policy of contracting credit may be neutralised by increased velocity of circulation, and vice versa. Cuuclusion. In spite of these limitations, however, there is a fairly close relationship between the sale and purchase of securities by the central bank and contraction and expansion, respectively, of bank credit. Since for the success of market operations it is necessary that there should be broad and active market in short and long-term government securities, and such markets exist only ill the; U.S.A. and Great Britain, this method of credit control has been most used in these two countries. In Great Britain especially, this method has been widely used with the objects of making bank rate effective, or ~ounteracting the effect of seasonal movements of funds, or offsetting the inflow and outflow of gold and for creating and maintaining conditions of cheap money in the interest of buslness. Credit Rationing.