Bank regulators across the globe, such as Reserve Bank of India (RBI), are entrusted with the task of providing adequate liquidity to the government and to the citizens. There are several ways of fulfilling its obligations. Printing currencies, altering interest rates on deposits or borrowing, issuing bonds etc are some of the widely used monetary policies. By adopting these means the central bank tries to control the flow of money/paper currency in the markets. Of course, these means bring along with them the positive and negative impact on the economy.
However, the most commonly used tool of monetary policy is Open Market Operations (OMOs), which takes place when the central bank sells or buys government treasury securities in order to influence the quantity of bank reserves and the level of interest rates.
When the apex bank conducts OMOs, it targets the federal funds rate, since that interest rate reflects credit conditions in financial markets very well.
So by definition OMOs are market operations conducted by RBI by way of sale/purchase of government securities to/from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis.
The term “open market” refers to the fact that the RBI doesn’t buy securities directly from the government. Instead, securities dealers compete on the open market based on price, submitting bids or offers to the Trading Desk through an electronic auction system.
If the apex bank decides to change the target range for the federal funds rate, the baton passes to the Trading Desk in the form of a policy directive. This directive includes the target range for the fed funds rate and an order to buy or sell government securities to hit that target.
The use of OMOs as a monetary policy tool ultimately helps the RBI pursue its dual mandate—maximizing employment,
promoting stable prices—by influencing the supply of reserves in the banking system, which leads to interest rate changes.
Apparently, the central bank is able to increase the money supply and lower the market interest rate by purchasing securities using newly created money. Similarly, the central bank can sell securities from its balance sheet and take money out of circulation, putting a positive pressure on interest rates.
We understand that if there is excess liquidity, RBI resorts to sale of securities and sucks out the rupee liquidity. Similarly, when the liquidity conditions are tight, RBI buys securities from the market, thereby releasing liquidity into the market.
Recently, the RBI decided to infuse Rs 10,000 crore liquidity in the banking system by buying government securities through OMOs.
The financial markets have been facing heightened volatility due to the spread of the Covid-19.
RBI had earlier infused Rs 25,000 crore of liquidity through Long-Term Repo Operations (LTRO).
Now we know that OMOs is on of the quantitative monetary policy tool which is employed by the central bank to regulate or control the total volume of money supply in the economy.
As we know, there are two types of OMO operations, an expansionary and contractionary. An expansionary open market operation is when the RBI wants to increase the money supply and lower interest rates by purchasing Treasury bills from banks, thus increasing the supply of bank reserves. The reverse activity is under taken during contractionary measures.
Let’s understand how OMOs take place…
OMOs are carried out by the central bank in association with the commercial banks. For conducting such operations, there is no involvement of the public.
Government bonds are mostly bought by commercial banks, financial institutions, high net worth individuals, large business corporations. All these entities maintain accounts with the bank and whenever these entities purchase bonds, the amount gets transferred to the central bank.
Thus, it can be said that OMOs have an impact on the deposits and reserves of the bank and also plays a role in their ability to provide credit.
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