Open Market Operations:
“An Open Market Operations refers to the exchange of securities between the central bank and the commercial banks or group of commercial banks or other financial institutions to regulate the supply of money and to stabilise inflation rate, exchange rate and interest rates.”
In other words, an Open Market Operations (OMO) is the activities such as purchase or sale of Government securities, Treasury Bills that are performed in an Open Market between the central bank and commercial banks or primary dealers to control money supply and to establish interest rates, inflation rate and exchange rate in the market.
The central bank either purchase or sell the government securities and treasury bills with the commercial banks or primary dealers in the open market to regulate the flow of funds in the system.
A central bank can also enter Repo lending or secured lending transactions against government securities as collateral with the commercial banks through an open market. In fact, the central bank being the monetary authority implements the monetary policy through open market operations in a country.
Functions of Open Market Operations (OMO):
The central bank utilises open market operations for the following reasons.
- OMO is used to inject money into the financial system or sometimes to suck out excess liquidity by the Reserve Bank of India, the Central Bank of India.
- The central bank, using OMO fixes the rate of interest, rate of inflation and rate of exchange.
- OMO also facilitates in borrowing funds for the central government or state government of a country.
- OMO facilitates commercial banks to borrow short-term advance (overnight or one day) through Repo Agreement during a liquidity crunch.
- It also facilitates the commercial banks or primary dealers to park their surplus funds with the central bank to earn interest through Reserve Repo Agreement.
Process of Open Market Operations (OMO):
The central bank of a country opens Loro account for different commercial banks which becomes Nostro Account from the commercial bank’s point of view. Also, notify that the balance in this account is of central bank’s money.
The Open Market Operations (OMO) are performed by simply debiting or crediting of the same account as money exists mostly in electronic form rather than physical currency (currency notes).
There is no need to transfer or create any physical currency (banknotes or coins) between the central bank and commercial banks to perform OMO provided commercial banks demand to exchange the electronic currency to physical currency.
In today’s scenario, most of the developed countries don’t allow for advances without having any approved securities as collateral. Therefore, the central bank has a right to declare the Government securities eligible for collateralised borrowings.
How the OMO establishes Monetary Target and flow of liquidity?
The Open Market Operations (OMO) establishes the relation between the central bank’s funds and interset rate (short term advances) just like the basic supply and demand theory of Economics.
In other words, if the demands of any goods or services increases, the price of those products will also increase. A similar pattern is followed in case of interest rates and the central bank’s funds.
Thus we can derive a formula, suppose the central bank wishes to enhance the supply of money in the economy, hence it has to purchase the Government Securities from the commercial banks or primary dealers, therefore, Loro account of central banks will be debited which leads to fewer demands of central bank’s money. Thus from the above conclusion, the interest rate will decline simultaneously which leads to a rise in inflation rate as well.
Conversely, if the central bank wishes to decrease the flow of funds in the market, it has to sell government securities to the commercial banks or other financial institutions. In this case, Loro account will be credited and hence interest rate will also rise. Thus the rate of inflation will also decline because of absorption of excess liquidity from the market.
In fact, the whole process works because the central bank has the capacity to inject and suck out the money in the system however other organisation might also influence the open market for a period of time. Though the central bank has more capacity to inject an infinite supply of funds to overcome the influence of other organisations.