six limitations of open market operations

 

Six limitations of open market operations

 

six limitations of open market

 

The effectiveness of open market operations as method of credit control is dependent upon the existence of a number of conditions, which limit the full working of this policy. Below are the six limitations of the open market operations:

 

1.      Lack of securities market

2.      Cash reserve ratio not stable

3.      Penal bank rate

4.      Bank act differently

5.      Pessimistic or optimistic attitude

6.      Velocity of credit money not stable

 

1.     Lack of securities market:

 

The first conditions are the existence a large and well organized security market. This conditions is needed for the operations of the open market because of without an organized market operation the apex bank will not be capable to purchase and sell securities in a larger quantity, and thereby influence the required reserve ratio of the commercial banks who are responsible for the distribution of money in the economy. Furthermore, the central bank must have plenty securities with it.

 

2.    Cash reserve ratio not stable:

 

The success of open market operation will also require the maintenance of a stable and coordinated cash reserve ratio by the commercial bank. It implies that whenever the apex bank sells or buys securities, the reserve of the commercial banks decrease or increase accordingly to maintain the fixed required ratio. But usually the commercials banks do not abide to the legal minimum reserve ratio and keep a higher ratio than this. This always makes the open market operations less effective in controlling the amount of volume of credit facilities.

 

3.    Penal bank rate:

 

A scholar called professor Ascheim, asserted that one of the necessary conditions for the success of the open market operations is a penal bank rate. If there is no penal discount rate fixed by the apex bank, the commercial banks can increase their borrowings from it when the demand for money or credit is strong on the part of the latter. In such moment, the scale of securities by the central bank to restrict monetary expansion will be unsuccessful. But if there is a penal rate of discount, which is a rate higher than the market rate of interest, the commercial banks will reluctant and slow to meet the apex bank for more additional financial help.

 

4.    Banks operate differently:

 

The Open market operations are very successful when the people act the way the apex bank expects them to behave. When the central bank sells securities, it expects the private sector which is the business community and other financial institutions to restrict the use of credit. If they simultaneously start dishoarding money, the act of selling securities by the apex bank, will not be a success in restricting credit. Also, the buying of securities by the central bank will not be effective if people start hoarding money in the economy.

 

5.    Optimistic / pessimistic attitude:

 

Optimistic or pessimistic attitude of the business community also limit the operation of the open market policy. When the apex bank buys securities and increase the supply of bank money, business men and women may be reluctant and unwilling to collect loans during a depression because of the prevailing pessimism among them. As aptly put by crowther, “on the other hand, if businessmen are optimistic during a boom, the sale of securities by the apex bank to contract the supply of bank money and even the rise in market rates cannot discourage them from getting loans from the banks. On the whole, this policy is more successful in controlling booms than depressions.

 

6.    Velocity of credit money not constant:

 

The success of open market operations depends upon a constant velocity of circulation of bank money. But the velocity of credit money is not constant. It increase during periods of brisk business activity and decrease in periods of may not be successful by increased velocity of circulation of bank credit.

 

Conclusion:

Despite these limitations, open market operations are more effective than the other instruments of credit control available with apex bank. This method is being successfully used for controlling credit in other developed nations where the securities market is highly developed and modern.

 

Other instrument of credit control;