Open Market Operations
Open market operations is another traditional or quantitative weapon at the disposal of central bank to control the volume of aggregate bank credit in the economy. The commercial bank create or destroy credit and enable businessmen to increase or decrease their total borrowing from them. Thus the banks have the power to expand or contract the economy of a country. The important function of central bank is to control the credit creating capacity of banks and through it to exercise control over the economic fluctuations in the country. Open market operations enable the central bank to perform this essential function. Open market operations refer to the buying and selling of government and other approved securities by the central bank in the money and capital markets.
Transactions in the money market are confined to those who deal in negotiable instruments falling due for payment within one year. Participants in these transactions include the commercial banks, business corporations various public agencies central bank and other specialised financial intermediaries which deal both on their own and on their clients accounts. The instruments traded in this market are discountable at the central bank and as such are partial substitutes for the high powered money. The transactions in the capital market are confined to negotiable instruments fixed interest perpetuities and equities have no fixed maturity date. The principal participants in the capital market are the commercial banks, insurance companies, industrial finance corporations, development banks. Investment trusts, provident funds and other specialised financial intermediaries who deal both on their own and on their clients accounts. The instruments traded in this market are not generally regarded as substitutes for high powered money. Although long term government securities may become fairly acceptable as such if the central bank decides to peg their prices so that will not fall below some known level.
The theory of open market operation is simple. During boom, which is considered dangerous for economic stability, the central bank sells the government and other approved securities from its securities portfolio in the market to reduce the aggregate supply of money in the economy. Buyers of these securities pay the central bank by drawing on their cash deposits in banks. Since the commercial banks hold deposits with the central bank, payment by the former to the latter means reduction in the size of the member banks deposits held with the central bank. Reduction in their cash reserves forces the banks to reduce their advances and refuse further loans. This reduces investment based on the bank credit and consequently the boom in the economy is checked. To fight slump in the economy the central bank buys the government and other approved securities in the securities market. It pays for these securities by issuing cheques drawn on itself to the individuals and institutional sellers of securities. The individuals deposits these cheques in their deposits accounts in the commercial banks. The commercial banks realise the proceeds of these cheques from the central bank consequently their cash reserves increase. The use these additional cash reserves to support the additional loans. Thus the aggregate commercial bank credit expands leading to greater investment more employment and higher prices in the economy. Thus by buying and selling securities in the money and capital markets, the central bank influences the credit creating operations of the commercial banks and through these operations it influences the economic conditions in the country.