Question

Explain the ‘open market operations’ method of credit control used by a central bank.

Answer 1

Open Market Operations (OMO) is a quantitative credit control approach in which the Central Bank buys or sells government securities (bonds) on the open market to regulate commercial banks' liquidity and loan-creating capacity.

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. With lower cash reserves, commercial banks are forced to curtail lending, raise interest rates, and limit credit creation. This contraction reduces the overall money supply, effectively lowering inflationary pressures.
2. Expanding Credit During Deflation: Conversely, during a recession or deflationary period, the Central Bank buys back government securities on the open market. The Central Bank compensates the sellers by injecting fresh cash liquidity directly into the commercial banking system, therefore significantly increasing commercial banks’ cash reserves. With extra liquidity, banks slash interest rates and aggressively extend loans to businesses and consumers. This flood of cheap credit stimulates investment, expenditure, and economic growth.