Limitations of Open Market Operations

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Limitations of Open Market Operations It is obvious that the above theory will be valid only if certain conditions are satisfied. The theory is that when the central bank purchases securities, the cash reserves of the member-banks will be actually increa

Limitations of Open Market Operations

It is obvious that this theory will be valid only if certain conditions are satisfied. These conditions are:

(i) The theory is that when the central bank purchases securities, the cash reserves of the member-banks will be actually increased, and conversely, the cash reserves will be decreased when the central bank sells securities. This, however, may not happen. The sale of securities may be offset by inflow of gold into the bank or by return of notes from circulation and hoards. The purchase of securities on the other hand, may be accompanied by an outflow of gold or withdrawal of notes for increased currency requirements or for hoarding. In both the cases, therefore, the cash reserves of the member-banks may remain unaffected.

(ii) But even if the cash reserves of the member-banks are increased or decreased, the banks may not expand or contract credit accordingly. The percentage of cash to credit is not rigidly fixed and can vary within quite wide limits. The banks will expand and contract credit according to the prevailing economic and political circumstances and not merely with reference to their cash resources.

(iii) The third condition is that when the commercial banks' cash resources increase, and the demand for loans and advances should increase too, and vice versa. This may not happen. Due to economic or political uncertainty even cheap money rates may not attract borrowers. Conversely, when trade is good and prospects of profits bright, entrepreneurs would borrow even at high rates of interest.

(iv) It is also assumed by the theory of open-market operations that the demand for credit is interest-elastic. But this may not be so. The demand for credit does not depend only on rates of interest. In a depressed situation, particularly, a fall in the interest rates may not be able to stimulate borrowings when the marginal efficiency of capital is very low. In that case even though banks' credit base is strengthened, they cannot create credit.

(v) The success of the open market operations is also limited by the preparedness of the central bank to incur losses. In short-term securities the loss is relatively less. Therefore, in actual practice, open market operations are often limited to dealings in short-term securities only.

(vi) So far as the central bank is concerned, purchase is easier than sale of securities in open market operations. Similarly, for commercial banks a policy of credit contraction is easier to implement than a policy of expansion. Thus, open market operations can stop booms but cannot prevent slumps.

(vii) Finally, the circulation of bank credit should have a constant velocity. But the velocity of bank deposits is rarely constant. It increases in periods of rising business activity and decreases in periods of depression. Thus, a policy of contracting credit may be neutralized by increased velocity of circulation, and vice versa.

In spite of these limitations, however, there is a fairly close relationship between the sale and purchase of securities by the central bank and contraction and expansion, respectively, of bank credit.

The success of open market operations requires that there should be a broad and active market in short and long-term government securities, as exists in the U.S.A. and Great Britain.

1 comment

Angelco Dimitrovski
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Posted on Dec 28, 2011