When use of bank rate is not effective enough in regulating the volume of money and credit, the central bank can resort to the use of open market operations. This instrument refers to the practice of sale and purchase of commercial paper (like trade and exchange bills) and government securities in the market. These days, even swapping operations {that is, simultaneous buying and selling of securities of different maturities) is also included in OMO. In practice, however, OMO are confined to government securities only. The manner in which this instrument is expected to work is as follows.
When the central bank sells securities, and receives sales proceeds from the buyers, an equivalent reduction takes place in the amount of cash (or balances with the central bank) held by the market. To the extent, the commercial banks lose cash balances; the capacity to create credit is reduced by a multiple of this loss. The net result is that there is a multiple reduction in the amount of money and credit available to the market. Similarly, when the central bank wants to increase the availability of money and credit in the market, it resorts to buying of securities and, in the process, loses cash to the market.
Another effect generated by OMO is that on rate of interest. Other things being equal, when the central bank sells securities, their prices fall. This, by itself, means an increase in the rate of return on securities of a corresponding increase in the market rate of interest. An increase in market rate of interest is also supported by the fact that the sale of securities results in a reduction in the availability of money and credit in the market. Similarly, when the central bank buys securities, other things being the same, an increase in their demand causes an increase in their prices and a corresponding reduction in the rate of return on them. Also, there is an injection of legal tender in the market and that leads to a fall in the interest rate.
Factors responsible for success of Open Market Operations (OMO):
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The success of OMO depends upon a number of factors including the following:
(a) The central bank should have a large volume and variety of securities so that it can buy and sell them to the extent needed. A wide maturity range also helps the central bank in reaching larger numbers of potential buyers and sellers. Moreover, with a wide range, it becomes easier for the central bank to influence specific interest rates.
(b) Success of OMO also depends upon the level of development of the financial markets and their sensitivity or responsiveness to changes in demand and supply of individual instruments. The net impact of OMO tends to remain confined to selected segments of the market if the financial system is not well integrated and developed. Moreover, whatever be the degree of response by the market, its impact tends to be long delayed. For these reasons, therefore, like bank rate, OMO also tend to be less effective in underdeveloped countries.
(c) Depending upon the manner in which they are used, OMO are expected to be effective in both expansion and contraction of the economy. However, if the banks have already an excess of cash reserves, then restrictive OMO are likely to help the banks in getting rid of the said excess. To the extent that happens, the contractionary effect on the economy gets neutralized. Similarly, a pumping in of cash balances through purchase of securities by the central bank may fail to expand credit if there is an insufficient demand for credit in the market.
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(d) There can be situations in which the banks may be able to partially counteract the variation in their cash balances by adjusting the composition of their remaining assets. For example, they may be able to counteract the contractionary effect of OMO by acquiring additional short-term assets.
(e) There is no fixed or stable quantitative relationship between OMO and their effect on the (i) volume of money and credit, and (ii) rate of interest. The cash deposit ratio maintained by banks varies with time and other circumstances. The inflationary and deflationary expectations also play their role.
(f) Because of their indiscriminate coverage, OMO are less suitable for use in underdeveloped countries.