Control Of Money Supply | Important Terms - CRR, SLR, RR, BR, RRR, Open Market Operations

Control Of Money Supply By The Central Bank

                           

The central bank of the country adopts various measures to handle or control the supply of money in the economy. Largely, these measures relate to credit supply of the commercial banks. These are broadly classified as:

• Quantitative Instruments, and
• Qualitative Instruments.

(A) Quantitative Instruments Of Credit Control

Qualitative Instruments are those instruments of credit control which focus on the overall supply of money in the economy. Supply of money is lowered to tackle inflation, and it is raised to tackle deflation.

Following are the points which are used in quantitative instruments of credit control in the economy:-

• Bank Rate: Bank rate refers to the rate of interest at which the central bank lends money to the commercial banks. It relates to instant (immediate) loan requirement of the commercial banks.

When bank rate is increased, market rate of interest is also increased. Accordingly, the cost of capital increases. This lowers the demand for credit and therefore, the supply of money tends to fall. Accordingly, inflation is corrected.

• Open Market Operations: Open Market Operations refers to the sale and purchase of securities in the open market by the central bank on the behalf of the government.

Inflation is corrected by selling the securities and soaking liquidity, while deflation is corrected by buying the securities and releasing the liquidity.

• Repo Rate: Repo Rate refers to the rate at which the central bank offers short period loans to the commercial banks by buying the government securities in the open market.

During inflation, the cost of capital is increased by the increasing the repo rate. This lowers the demand for the credit and accordingly, the supply of money in the economy. On the other hand, during deflation, the cost of capital is reduced by reducing the repo rate. This increases the demand for credit and accordinly, the supply of money in the economy as desired.

• Reverse Repo Rate: The rate at which the central bank accepts deposits from the commercial banks (through government securities) is known as 'Reverse Repo Rate. It is also called as Reverse Repurchase Rate.

Due to rise in reverse repo rate, inflation is controlled. Accordingly, due to fall in reverse repo rate results controlled in the deflation.

• Cash Reverse Ratio (CRR): Cash Reserve Ratio refers to the minimum percentage of the bank's total deposits required to be kept with the central bank. It is fixed by the central bank and is varied from time to time to regulate the supply of money in the economy.

When the supply of money is to be increased, CRR is lowered and when the supply of money is to be decreased, CRR is raised.

• Statutory Liquidity Raatio (SLR): Every bank is required to maintain a fixed percentage of his assets in the form of liquid assets, called SLR. The liquid assets include: cash, gold, unencumbered approved securities. 

When the supply of the money is to be increased, SLR is lowered and when the supply of money is to be decreased, SLR is raised.

(B) Qualitative Instruments Of Credit Control

Quantitative Instruments are those instruments of credit control which focus on select select sectors of the economy. These instruments are used to increase or decrease the supply of money to select sectors of the economy. (These are those sectors which are the principal source of instability in the economy).

Broadly, the qualitative instruments are placed in three categories, as under:

• Margin Requirement: The margin requirement refers to the difference between the current value of the securities offered for loan (called collateral) and the value of loan granted.

The margin requirement is raised when the supply of money needs to be reduced. The margin requirement is lowered when the supply of money is to be increased. Often the margin requirement is kept high for the speculative (trading) activities in the economy.

• Rationing Of Credit: Rationing of credit refers to the fixation of credit quotas for different business activities. 

Rationing of credit is introduced when the supply of credit is to be checked particularly for speculative activities in the economy.The central bank fixes credit quota for different business activities. The commercial banks of the country cannot exceed the quota limits while granting loans to the public. This restricts the supply of money in the economy, and inflation is controlled. On the other hand, rationing of credit (if already in practice) is withdrawn to increase the supply of money. This controls deflation.

• Moral Suasion: It is like rendering an advice to the commercial banks by the RBI to follow its directives.

The banks are advised to restrict loans during inflation in the economy, and be liberal in lending during deflation in the economy.

It is most important to control the supply of money in the economy because when the supply of money is increased in the economy, it resulted inflation in the economy and when the supply of money is decreased in the economy, it resulted deflation in the economy. By applying the Quantitative and Qualitative Instruments of credit control into the economy the government controls the inflation and deflation in the economy through the central bank of the country.