What Are The Disadvantages Of Open Market Operations?

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Mahwash Marcel Profile
Mahwash Marcel answered
This method is adopted by the central bank to expand or contrast credit money in the market. Under this method the bank either sells or purchases government securities to control credit. When it wants to expand credit it starts purchasing government securities with the result that more money is pumped into the market. This money in return, is deposited with the commercial banks which become more competent to grant a greater amount of loans thereby expanding credit in the market.

On the other hand when the central bank wants to contrast credit it starts selling the government securities owing to which market money goes to the central bank with the result that money in the market is reduced. The deposits of commercial banks go down, weakening their power to lend.

This method will work when the following conditions are fulfilled.
1. The method should affect the reserves of commercial banks. They should contract or expand as a result of Open Market Operations (OMO). The method would fail if the bank reserves remain unaffected.

2. Demand for bank loans should increase or decrease in line with the increase or decrease in the bank cash reserves and rate of interest.

3. Circulation of bank credit should remain unchanged.
Nouman Umar Profile
Nouman Umar answered
There are some disadvantages of the open market operation in a specific situation. If the money market is not developed the central bank will not be able to exert full control over the bank reserves. If the commercial banks have surplus reserves with them and they resort to easy lending policy, the sale of government securities may not have the desired effect of reducing the cash reserves of the commercial banks. If there is return of notes from circulation and hoards the sale of securities may not be able to reduce the cash reserves of member banks.

Similarly if there are withdrawals of notes for increased currency requirements or hoarding than the purchase of securities may not increase the cash reserves of the commercial banks. There is no fixed ratio of cash to credit for the member banks. If the economic and political conditions are favourable the banks may expand credit by multiple with low cash reserves. In case of the loan conditions are not favourable the banks may contract credit even though they have sufficient cash reserves with themselves. It is assumed in the theory of open market operation that the demand for bank credit is interest elastic the higher the rate of interest the lower is borrowing and spending.

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