How Monetary Policy Correct deficient demand situation

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

Monetary Policy:

Monetary policy can be used effectively to control the situation of deficient 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 deficient 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 deficient demand.

Bank rate:

Bank rate is the rate at which the central bank lends money to the commercial banks.To control the situation of deficient demand, bank rate is decreased, due to this reduction of  bank rate by central bank, commercial banks will fall the market rate of interest(the rate at which commercial bank lend money to the consumers and investors).This will lead to lower cost of borrowing from commercial banks to the consumers and investors. This increases demand for credit, thereby leading to more liquidity in the hands of the people. Consumption expenditure and investment expenditure are raised and aggregate demand (AD) will rise.

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 raised in the economy (during situation of deficient demand), the central bank purchase more and more securities. This increases the cash holdings of the commercial banks (purchase of securities inject purchasing power in the market), thereby increasing loans and advances by them.Thus, leading to rise 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 decreased aggregate demand, central bank lowers the CRR(for say from 20 to 10 % as in example), implying that commercial banks have to keep less cash reserve with the central bank.

For example:

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)

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)

Lending capacity of the banks is increased (credit creation of the banks rises) thereby increasing 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 decreased Aggregate demand SLR is lowered like CRR.Implying, that commercial banks have to keep less reserves with the central bank. Lending capacity of the banks is raised thereby increasing consumption and investment expenditure financed through bank credit.