How does the Central Bank control Flow of Credit - Monetary Policy

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.

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.

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.