By buying or selling bonds, bills, and other financial instruments in the open market, a central bank can expand or contract the amount of reserves in the banking system and can ultimately influence the country's money supply. When the central bank sells such instruments it absorbs money from the system. Conversely, when it buys it injects money into the system. This method of trading in the market to control the money supply is called open market operations.
Open market operations are the major instrument of monetary control in industrial countries and are becoming important to developing countries and economies in transition. Open market operations allow central banks great flexibility in the timing and volume of monetary operations at their own initiative, encourage an impersonal, businesslike relationship with participants in the marketplace, and provide a means of avoiding the inefficiencies of direct controls.
There are two types of open market operations:
OUTRIGHT OPEN MARKET OPERATIONS
- Outright open market operations are permanent in nature, when the central bank buys these securities (thus injecting money into the system), it is without any promise to sell them later.
- Similarly, when the central bank sells these securities (thus withdrawing money from the system), it is without any promise to buy them later. As a result, the injection/ absorption of the money is of permanent nature.
REPURCHASE AGREEMENT OR REPO
- However, there is another type of operation in which when the central bank buys the security, this agreement of purchase also has specification about date and price of resale of this security.
- This type of agreement is called a repurchase agreement or repo.
- The interest rate at which the money is lent in this way is called the repo rate.
REVERSE REPURCHASE AGREEMENT OR REVERSE REPO
- Similarly, instead of outright sale of securities the central bank may sell the securities through an agreement which has a specification about the date and price at which it will be repurchased. This type of agreement is called a reverse repurchase agreement or reverse repo.
- The rate at which the money is withdrawn in this manner is called the reverse repo rate. The Reserve Bank of India conducts repo and reverse repo operations at various maturities: overnight, 7-day, 14- day, etc.
These types of operations have now become the main tool of monetary policy of the Reserve Bank of India.