How Monetary Policy Correct Excess demand situation

After going through Fiscal Policy to control the situation of excess demand, we will know see how monetary policy of the government can be used to solve the situation of increased aggregate demand.

Monetary Policy:

Monetary policy can be used effectively to reduce the excess demand. Monetary policy is the policy of the central bank to achieve various policy of economic policy  which includes components like bank rate, open market operations, cash reserve and statutory liquidity ratio to correct excess demand.Following are the principal components of Monetary policy. Along with each component, we are describing the way it is used to correct situations of excess demand.

Bank rate:

Bank rate is the rate at which the central bank lends money to the commercial banks.

To control the situation of excess demand, bank rate is increased, due to this increase of bank rate by central bank, commercial banks raise the market rate of interest(the rate at which commercial bank lend money to the consumers and investors). This will lead to higher cost of borrowing from commercial banks to the consumers and investors. This reduces demand for credit, thereby leading to less liquidity in the hands of the people.Consumption expenditure and investment expenditure are reduced and aggregate demand (AD) will fall.

Open market operation:

Open market operation refers to the sale and purchase of government and other approved securities by the central bank to the commercial bank and other financial institutions. When cash balance is to be reduced from the economy (during situation of excess demand), the central bank sells more and more securities with lured interest rates. This reduces the cash holdings of the commercial banks, thereby restricting loans and advances by them. So expenditure financed through bank credit will fall as sale of securities sucks purchasing power from the market. So leading to fall in aggregate demand.

Cash Reserve Ratio:

Cash reserve ratio (CRR) is the ratio of bank deposits which the commercial banks are required to keep with the central bank. CRR is a direct, quick and effective method of controlling the power of commercial banks to give loans and advances.

At the situation of increased aggregate demand, central bank raises the CRR (for say from 10 to 20 % as in example), implying that commercial banks has to keep more cash reserve with the central bank.

For example: 

Minimum reserve ratio = 10% (as fixed by central bank)

Total deposit = Rs.100 crore

Minimum reserve = 10 % of Rs. 100 crore = Rs. 10 crore (with central bank) 

If Minimum reserve ratio is raised to = 20% (as fixed by central bank)

Total deposit = Rs.100 crore

Minimum reserve = 20 % of Rs. 100 crore = Rs. 20 crore (with central bank) 

Lending capacity of the banks is restricted thereby reducing consumption and investment expenditure financed through bank credit.

Statutory Liquidity Ratio:

Statutory Liquidity Ratio (SLR) refers to the ratio between liquid assets and total assets of the commercial banks. The commercial banks are required to maintain minimum SLR as fixed by the central bank from time to time. At the situation of increased Aggregate demand SLR is raised like CRR. Implying, that commercial banks has to keep more reserves with the central bank.

Lending capacity of the banks is restricted thereby reducing consumption and investment expenditure financed through bank credit.