In case, the liquidity condition of the economy is weak, the central bank purchases government securities and hence infuses money into the system. Otherwise, it sells securities in case of excess liquidity in the system.
The central bank performs open market operations considering the targets for various economic parameters such as interest rates, exchange rates or inflation. Also, the measure is used as a tool for
Open Market operations in India
Before, the financial reforms of 1991, cash reserve ratio (CRR) and statutory liquidity ratio (SLR) were the prime tools used by the central bank to control money supply and interest rates in the market. But soon, both the parameters lost their importance and implementation of open market operations scaled immensely as OMOs are deemed comparably effective in correcting market liquidity.
The Reserve Bank of India in India performs OMO in two ways :
1. Outright Purchase (PEMO): Through PEMO, RBI out-rightly engages in purchasing and selling of securities for expanding or contracting the money-supply for a long-term.
2. Repurchase Agreement ( REPO): RBI through REPO engages in securities sale or purchase with a condition to repurchase.
Working of OMOs :
Whenever, RBI engages in OMOs to purchase government securities through either PEMO or repo agreement, its financial assets on the balance sheet increase by the amount of purchase. For the same, the central bank writes a cheque to the bank or participating institution from which RBI has purchased the securities.
The institutions then deposit the cheque in their account held with a commercial bank, which then sends the cheque for clearance to the RBI. With this, liabilities side of the balance sheet of RBI increases as the amount of reserves of the bank with the central bank increases. According to the relationship, M3=MB*m (where M3 is money supply, MB is monetary base and m is a multiple figure), with an increase in the monetary base (MB) or monetary liability; money supply or M3 increases by multiple m. Conversely, in case of securities sale by the RBI, money supply decreases in the market with decrease in the monetary base or liability of the central bank.