Open Market Operations (OMO)

Open Market Operations (OMO)is a process of carrying out by the central bank of an economy to provide or withdraw liquidity from financial institutions, either individually or collectively. This mechanism allows the RBI to manage liquidity conditions in the economy. In this article, you will learn definition, types, advantages, disadvantages, etc.

This article will provide key insights for GS Paper-III Economy of UPSC IAS Exam.

Table of Content

• What is Open Market Operation?             
• Steps of Open Market Operations
• Types of Open Market Operations
• Advantages of Open Market Operations
• Disadvantages of Open Market Operations
• Conclusion          
• Frequently Asked Questions        

What is Open Market Operation?

• An Open Market Operation (OMO) is a process of carrying out by the central bank of an economy to provide or withdraw liquidity from financial institutions, either individually or collectively.
• The main aim of OMO is to enhance the liquidity position of commercial banks and absorb excess liquidity from them.
• In India, this operation is controlled by the Reserve Bank of India.

Steps of Open Market Operations:

• The central bank conducts OMO as part of its monetary policy by taking specific actions based on economic conditions.
• Through the Open Market Operations, the central bank seeks to regulate economic conditions and achieve monetary stability.
• These actions can be of two types:
  • Purchasing Government Bonds from Banks
  • Selling Government Bonds to Banks

Purchasing Government Bonds from Banks:

• When the central bank buys government bonds, it usually occurs during a recessionary phase with significant unemployment issues in the economy.
• By purchasing government bonds, the central bank injects money into the economy, increasing the money supply.
• This leads to a decrease in interest rates, stimulating consumption and investments, and ultimately raising aggregate demand.
• Result: the real Gross domestic product (GDP) also experiences growth.
  • Real GDP is GDP given in constant prices and refers to the volume level of GDP. 
• This approach is known as Expansionary Monetary Policy as it increases the real GDP of the economy.

Selling Government Bonds to Banks:

• In contrast, when the economy faces inflation, the central bank uses many measures such as controlling it by selling government bonds to banks.
• Selling government bonds helps drain excess money from the economy, leading to a decrease in the money supply.
• Consequently, interestrates rise leading to a decline in consumption and investmentspending, and ultimately reducing aggregate demand.
  • This results in a fall in real GDP.
• This method is known as Contractionary Monetary Policy as it decreases the real GDP of the economy.

Types of Open Market Operations:

• There are two types of Open Market Operations: Permanent and Temporary.

Permanent Open Market Operations:

• These involve the buying and selling of government securities.
• The aim of such an operation is to achieve long-term benefits, such as controlling inflation, managing unemployment, and regulating the currency in circulation.

Temporary Open Market Operations:

• These are carried out for short-term reasons, like meeting reserve requirements or providing short-term liquidity.
• Temporary operations are executed through repo or reverse repos.
  • Repo is a form of short-term borrowing, mainly in government securities.
  • Reverse Repo is a short-term agreement to sell securities in order to buy them back at a higher price.
• Overnight repos and reverse repos are examples of temporary open market operations.
• They address short-term liquidity needs and maintains stability in the financial system.

Advantages of Open Market Operations:

• It helps to manage interest rates and control inflation.
• The central bank aims to keep inflation within a specific range to ensure the country’s economy grows steadily.

When securities are sold:

• When the central bank offers securities and government bonds to other banks and the public, it impacts the supply and demand of credit.
• Buyers of these bonds deposit money into the central bank’s account which reduces their reserves.
• The bond prices decrease, causing interest rates to rise.
• Higher interest rates then lead to a decrease in the demand for credit.
• Result: commercial banks have less money to lend to the public, leading to a decrease in their capacity to create credit and affects the overall credit supply.

When securities are bought:

• When the central bank buys securities, the cycle is reversed, causing inflation to rise and interest rates to decrease.
• The central bank can also target and control the money supply in the economy.
• When it detects excess liquidity in the banking system, it may sell bonds to absorb the surplus liquidity.
• Conversely, if liquidity is low, it may buy bonds to inject more money into the system.
• These operations may also be used to regulate the value of the country’s currency concerning fiat currencies and foreign currencies.

Disadvantages of Open Market Operations:

• There must be a broad, strong and active securities market for large-scale and successful open market operation.
  • In absence of it the Open Market Operations will not be successful.
• The sale of securities by the central bank can be ineffective to stop the loanable resources of the banks as rediscounting may replenish the reserve as previous condition.
• The success of OMO may be hindered by the preparedness of the central bank to incur losses.
• The execution of a purchase policy and the sale of securities in open market operation by the central bank are difficult. 
• When a large-scale of securities is affected by the central bank, the prices of securities may affect bank assets and hamper the government’s borrowing programme.

Conclusion

Open Market Operations (OMOs) are a crucial tool employed by the Reserve Bank of India (RBI) to manage liquidity and influence credit conditions in the economy. By strategically buying or selling government securities, the RBI can achieve various monetary policy objectives.

OMOs offer a flexible and targeted approach to monetary management. They are crucial for achieving price stability, promoting economic growth, and ensuring the smooth functioning of the financial system. By effectively utilizing OMOs, the RBI can navigate complex economic situations and foster a healthy financial environment for India’s growth.

Ref: Source-1

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