Question

(3 Marks) Define open market operations, and explain how executing them can be used as a tool for the conduct of monetary policy.

Answer 1

Open market operations is  an instrument of monetary policy and its primary aim is to influence the money supply in the economy. It refers to buying or selling of government securities by central bank with the motive to increase / decrease the money supply in the economy.

The central bank can either buy or sell government bonds in the open market (this is where the name was historically derived from) or, which is now mostly the preferred solution, enter into a repo or secured lending transaction with a commercial bank: the central bank gives the money as a deposit for a defined period and synchronously takes an eligible asset as collateral. A central bank uses OMO as the primary means of implementing monetary policy.

For instance suppose central bank wants to increase money supply in the economy so one way it can do that is to buy bonds / securities from the market thereby releasing liquidity. Similarly bank resorts to sale of government securities to suck out rupee from the system in cases of excess liquidity in the economy.