Limitations of open market operations, Managerial Economics

Limitations of Open Market OperationsLimitations

For their success central bank open market operation assume that commercial banks in the country will expand their credit port folio when they get additional cash and contract it when their cash reserves fall as a consequence of central bank open market operations. But it may not happen because expansion and contraction of credit to great extent reflects the prevailing business mood or psychology of the investors. During boom businessmen are over optimistic about the future and commercial banks will not readily restrict their loans even though their cash reserves at the central bank are reduced by latter open market operations. Either the commercial banks may work with the low cash reserves or they may replenish their cash reserves by discounting securities (part if which they may have bought from the central bank )at the central bank. Consequently what the central bank does on the one side as the controller of credit may be nullified by the action of commercial banks who might resort to jthe central bank as the lender of last resort . in depression , the act of buying the securities from the commercial banks on the part of the central bank may fail to induce the banks to expand credit despite their cash reserves. Since in depression lending becomes more risky on account of the growing failure of firms. The commercial banks adopt the policy of wit and see and work with higher reserves rather than expand credit on the basis of their surplus cash reserves. As the ultimate custodian of public deposits kept with the commercial banks, the central bank cannot force the commercial bank to lend when the latter l are not inclined to lend. Moreover , in depression it is not merely that the commercial banks are reluctant to lend, it difficult to find borrowers in enough numbers who are able and willing to launch new ventures and enterprises. Even if the banks shake away their pessimism and show readiness to lend, it may not bear any fruit in practice. The pumping in of additional money by the central bank trough it open market operations( purchases of securities ) may only result in expapanding the surplus cash reserves of the banks without causing any increase in credit due to of investors reluctance to borrow from the bank even at the most liberal terms. This was witness in 1932-33 in England when the total deposits of the London clearing bank increased by 214 million while their loans and advances fell by 77 million. While the central bank can increase the amount of money in the system by purchasing securities in the open market in order to fight depression there is no method by which it can force the investors to incest this additional cash into productive enterprise.

Moreover, the ability of central bank to influence the money market through its open market operations is limited by the total supply of suitable securities which it can unload in the market to check inflation and also by its own preparedness to purchase securities at high prices to check slump and incur losses by selling them at low prices to check boom. Even if the central bank is ready to suffer losses to establish stability in the economy, it is likely that the total amount of securities which it may have its portfolio might prove inadequate to achieve the much needed economic stability pointing out to this limitation of central bank open market operations . Keynes rightly remarked that the reserve bank can only fire off against an incipient boom. Only such ammunition as they have been able to pick up while resisting a slump. The inadequacy of this ammunition was experienced in the unhappy situation of the federal reserve bank during the recovery of 1935-37 when the excess cash reserves of the commercial banks reached 3300 million. dollars as against the total holdings of US government securities held by the federal reserve bank of the value of only 2400 million dollars. In such a situation, even the sale of the entire securities by the federal reserve bank would have proved inadequate to absorb the excess cash reserves of the member banks. Consequently even the ammunition which the central bank may possess cannot always be fired off. Thus the open market operations policy of the bank is a blunt edged weapon.

The extent of success of central bank open market operations mainly depends on the stage of development of the money and capital markets in the economy and the extent to which the central bank is prepared to indulge in the buying and selling operation. In the underdeveloped economies where the money and capital markets are undeveloped, where the central bank lack enough experience in the use of the technique of open market operations, where the central banks do not possess the portfolio of securities in the of the size and maturity composition such that the may sell the necessary securities in the prescribed volume in the market and where the absorbing capacity of the capital market is low restricting the field of operations for the central bank, the scope for the open market operation sis much more severely restricted.

Thus despite the theoretical excellence of the open market operations as an important instrument of central bank credit control policy in practice it is of little use. Researches made in the study of the business cycles reveal that credit expansion or contraction is not the primary cause of the occurrence of business cycle in the economy. It is only a secondary cause which at best accelerates the process of expansion or contraction. Only market operations are however employed to influence the rate of interest and the prices of government securities in the money market.

In spite of the difficulties in the open market operations. In the countries having well developed and highly active money and capital markets. Open market operations are one of the principal instruments used for monetary regulation by the authorities, as is illustrated by the experience of the united states and the united kingdom. In other countries where the capital market( and to some less extent the money market also) in not so well developed. Open market operations as an instrument of monetary regulation are relatively unimportant .

Posted Date: 12/1/2012 7:12:56 AM | Location : United States

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