Management of money supply is an important
function of Central bank. High fluctuations in the volume of money (money
supply) create the problems of inflation (excess demand) and deflation
(deficient demand)
The central bank uses the Monetary Policy / Credit Policy for monetary management.
Monetary Policy is the
policy of the central bank to regulate the availability, cost and use of money
for achieving certain given objectives of the economic policy.
Principal instruments of monetary policy or
credit control of the central bank of a country are broadly classified as:
Quantitative
Instruments
|
Qualitative
Instruments
|
Quantitative
methods aim at controlling the cost and quantity of credit created by the
commercial banks by using such weapons as bank
rate, open market operation, cash reserve ratio and statutory reserve ratio.
|
Qualitative
methods are designed to regulate the use and direction of credit by using
such weapons as selective credit control, moral suasions and
direct action.
|
Quantitative
methods are the traditional methods of
credit control.
|
Qualitative
measures are Selective methods of credit
control.
|
Quantitative Instruments Of Monetary Policy
We will now discuss various instruments of
monetary policy which affect overall supply of money in the economy.
1) 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(inflation),
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
and money supply in economy falls, thereby leading to less liquidity in the
hands of the people.Consumption expenditure and investment expenditure are
reduced and aggregate demand (AD) will fall.
To control the situation of deficient demand (deflation),
bank rate is decreased, due to this
reduction of bank rate by central bank, commercial banks will fall the market
rate of interest.
This will lead to lower cost of borrowing from
commercial banks to the consumers and investors. This increases demand for
credit and money supply rises, thereby leading to more liquidity in the hands
of the people. Consumption expenditure and investment expenditure are raised
and aggregate demand (AD) will rise.
Thus by increasing or
decreasing the Bank rate, money supply in the economy can be regulated.
In
Indian Context:
In India RBI (Reserve Bank of India) has
replaced bank rate with “Repo Rate”
and “Reverse Repo Rate”
Repo
Rate or
repurchase rate refers to the bank
rate at which RBI offers loans to the commercial banks for short period against
government bonds.
RBI buy government
bonds from banks with an agreement to sell them back at a fixed rate.
To control the situation of excess demand (inflation),
repo rate is increased, due to this
increase of repo rate by central bank, commercial banks finds more expensive to
borrow money, thus money supply in the economy will fall.
To
control the situation of deficient demand (deflation), repo rate is decreased, due to this reduction of
repo rate by central bank, commercial banks finds cheaper to borrow money. Thus
money supply in the economy will rise.
Reverse Repo
rate
is the rate of interest at which the RBI borrows from commercial banks for
short period.
This
is done by selling government bonds
to banks. The bank utilizes the reverse repo rate facilities to deposit their
short term excess fund with the RBI and earn interest on it.
At the time of high money supply in the
economy (inflation) reverse repo rate is increased,
luring commercial banks to earn high interest in their excess fund. This will
decrease money holding with commercial banks(less credit creation), thus money
supply in the economy will fall.
At
the time of low money supply in the economy (deflation) reverse repo rate is decreased, commercial banks will be
less interested to keep their money with RBI (as interest falls).
This will increase money holding with
commercial banks (more credit creation), thus money supply in the economy will
rise.
2) 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 (Money supply) is to be reduced from the economy (during situation
of excess demand, inflation), 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.
When
cash balance (Money supply) is to be
raised in the economy (during situation of deficient demand, deflation), 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.
Thus by selling or purchasing
government securities in open market, money supply in the economy can be
regulated.
3) 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.
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)
At
the situation of increased aggregate demand, central bank raises the CRR ( for
say 10 to 20 % as per example), implying that commercial banks has to keep more
cash reserve with the central bank.
Lending
capacity of the banks is restricted thereby reducing consumption and investment
expenditure financed through bank credit.
At
the situation of decreased aggregate demand, central bank lowers the CRR( for
say 20 to 10 % as per example), implying that commercial banks have to keep
less cash reserve with the 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.
Thus by increasing or decreasing the CRR,
money supply in the economy can be regulated.
4) 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.
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.
Thus by increasing or decreasing the SLR,
money supply in the economy can be regulated.
Also
read :
1)
Monetary Policy – Correcting deficient demand situation
2)
Monetary Policy – Correcting excess demand situation
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