The open market operations as a method of quantitative credit control are interpreted in two ways. In a broad sense, it refers to the buying and selling of government securities as well as other eligible papers like bills and securities of private concerns by the central bank. In a narrow sense it means the buying and selling of only government securities by the central bank in the money market. The process of open market operations affects the volume of credit, the level of business activity and the internal price level. The process is explained below.
Suppose in an economy there is inflationary tendency and the expansion of credit is very high and the central bank wants to control this. Then the central bank will start selling securities in the open market to both the banks as well as the private individuals. When these securities are bought, payment is made in terms of cash. This will bring down the cash reserve of the commercial bank with which they can only crease lesser credit. As a result the expansion of credit will be reduced. Similarly, suppose the central bank wants to expand credit in order to revive an economy in deflationary situation. Then it will start buying securities in the open market from the commercial banks and others. This means, the central bank will pay them cash adding to their cash reserve. This will enable commercial banks to create more credit. Apart from expanding or contracting credit creation, open market operation can also influence the interest rate. For instance, when the central bank buys securities giving cash, the interest rate will fall down and when the securities are sold, the interest rate will go up.
The open market operations became very popular since the First World war. With the increased availability of government and other securities, it has become more useful. As the bank rate was proved to be ineffective, there was need to make increasing use of open market operations. Further it has helped to remove the shortage of money in the money market apart from helping to make the bank rate policy successful. A major contribution of the open market policy is that it is very helpful in checking the ‘run on banking.’ However, the success of the open market operation depends on the following conditions:
- Existence of a well developed securities market is a must for making the policy effective. The non-fulfillment of this condition has made this policy less effective in under developed countries.
- The maintenance of excess cash reserve by the commercial banks defeats the object of this policy easily.
- The operations of extraneous factors like leakage of cash or injection cash into the country may affect the effectiveness of this policy. Suppose when the central bank buys securities, the injection of additional cash be used to set right the balance of payment deficit or people may holding more cash or the velocity of money may decline. As a result policy becomes ineffective.
- The attitude of the borrowers may stand in the way of this policy succeeding, suppose the central bank wants to expand credit and so buys securities. The availability of credit need not induce the investors to borrow more from commercial banks. That is if the investor’s attitude is not in consonance with the policy of the central bank, the open market operation will fail.
- The central bank should have adequate stock of securities to effectively, participate in the open market operations.
- The commercial banks should not have any other way of getting financial accommodation from the central bank as otherwise die open market operations will be less effective.
- It has been found in practice that this policy is more effective in controlling credit creation or expansion rather than in stimulating credit expansion as the borrowers are influenced by other factors apart from the cheapness of credit.