This method of credit control developed after the First World War.
OMO refers to buying and selling of government securities and other eligible paper like bills and securities of private concerns by the central bank in the open market.
PURCHASE OF SECURITIES
During deflationary conditions
when there is less purchasing power in the economy
When the central bank purchases securities
money flows from central bank to commercial bank
this increases the cash balances of the commercial banks
this increases their capacity to create credit
therefore the market rate declines
loans and advances by commercial banks increases
helps expansion of credit and
increases money supply
SALE OF SECURITIES
During inflationary conditions,
When the central bank sells securities
money flows from commercial banks to the central bank
this reduces the cash balances of the commercial banks
this reduces their capacity to create credit
therefore the market rate rises
loans and advances by commercial banks decreases
helps contaction of credit and
decreases money supply
In India however the OMO has not been very effective because the market for government securities is not well organized and developed.
Conditions for success or limitations of OMO
This method can be successful only if the securities market is well-developed.
This method is ineffective if commercial banks have excess cash reserves.