Question

How does open market operations act as a method to control credit?

Answer 1

Open Market Operations (OMO) is a quantitative method in which the Central Bank purchases or sells government securities (bonds) in the open market to control the money supply and credit creation capability of commercial banks.

1. Controlling Credit During Inflation: When the economy is facing high inflation, the central bank sells government securities to commercial banks and the public. Buyers pay for these securities using bank deposits, which immediately depletes cash reserves in the commercial banking system. Commercial banks are being obliged to cut back on lending and contract credit creation due to significantly lower cash reserves. This reduction in the overall money supply diminishes purchasing power and effectively alleviates inflationary pressures.
2. Expanding Credit During Deflation: Conversely, during a recession or deflationary era, the Central Bank buys back government securities on the open market. The Central Bank pays the sellers by injecting fresh cash liquidity directly into the commercial banking system, thus significantly increasing commercial banks’ cash reserves. With surplus liquidity, banks are greatly motivated to reduce interest rates and aggressively increase credit to businesses and consumers. This flood of cheap financing boosts investment, expenditure, and economic growth.