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.
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.
