Chapter-I INDIAN ECONOMY ON EVE OF INDEPENDENCE

Central Bank as a Controller of Money Supply or Credit:

Principal instruments of Monetary Policy or credit control of the Central Bank of a country are broadly classified as:

(a) Quantitative Instruments or General Tools; and
(b) Qualitative Instruments or Selective Tools.

(a) Quantitative Instruments or General Tools of Monetary Policy: These are the instruments of monetary policy that affect overall supply of money/credit in the economy. These instruments do not direct or restrict the flow of credit to some specific sectors of the economy. They are as under:
(i) Bank Rate (Discount Rate)
• Bank rate is the rate of interest at which central bank lends to commercial banks without any collateral (security for purpose of loan) for long term.

• In a situation of excess demand leading to inflation,
 Central bank raises bank rate that discourages commercial banks in borrowing from central bank as it will increase the cost of borrowing of commercial bank.
 It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans.

It reduces purchasing power of the people.

Money supply falls in the economy.

Excess demand reduces and inflation is corrected.

• In a situation of deficient demand leading to deflation,
-> Central bank decreases bank rate that encourages commercial banks in borrowing from central bank as it will decrease the cost of borrowing of commercial bank.
-> Decrease in bank rate makes commercial bank to decrease their lending rates, which encourages borrowers from taking loans.
 It increases purchasing power of the people.

Money supply rises in the economy.

Deficient demand rises and deflation is corrected.

 (ii) Repo Rate
• Repo rate is the rate at which commercial bank borrow money from the central
bank for short period by selling their financial securities to the central bank.
• So, keeping securities and borrowing is repo rate.
• In a situation of excess demand leading to inflation,
-> Central bank raises repo rate that discourages commercial banks in borrowing from central bank as it will increase the cost of borrowing of commercial bank.
-> It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans, which discourages investment.
-> It reduces purchasing power of the people.

Money supply falls in the economy.

Excess demand reduces and inflation is corrected.

• In a situation of deficient demand leading to deflation,
-> Central bank decreases Repo rate that encourages commercial banks in borrowing from central bank as it will decrease the cost of borrowing of commercial bank.
-> Decrease in Repo rate makes commercial bank to decrease their lending rates, which encourages borrowers from taking loans, which encourages investment.
-> It increases purchasing power of the people.

Money supply rises in the economy.

Deficient demand rises and deflation is corrected.

(iii) Reverse Repo Rate
• It is the rate at which the Central Bank (RBI) borrows money from commercial bank.

• In a situation of excess demand leading to inflation-

 Reverse repo rate is increased by Central Bank, it encourages the commercial bank to park their funds with the central bank to earn higher return on idle cash. It decreases the lending capability of commercial bank. It reduces purchasing power of the people.

Money supply falls in the economy.

Excess demand reduces and inflation is corrected.

• In a situation of deficient demand leading to deflation,-

 Reverse repo rate is decreased by Central Bank, it discourages the commercial bank to park their funds with the central bank. It increases the lending capability of commercial banks,

 It increases purchasing power of the people.

Money supply rises in the economy.

Deficient demand rises and deflation is corrected.

 (iv) Open Market Operations (OMO)
• It consists of buying and selling of government securities and bonds in the open market by the Central Bank.
• In a situation of excess demand leading to inflation- central bank sells government securities and bonds to commercial bank. With the sale of these securities, the power of commercial bank of giving loans decreases.

It reduces purchasing power of the people.

Money supply falls in the economy.

Excess demand reduces and inflation is corrected.

 

• In a situation of deficient demand leading to deflation,-

Central bank purchases government securities and bonds from commercial bank. With the purchase of these securities, the power of commercial bank of giving loans increases.                         It increases purchasing power of the people.

Money supply rises in the economy.

Deficient demand rises and deflation is corrected.

 (v) Varying Reserve Requirements(or LRR)-
• Banks are obliged to maintain reserves with the central bank, which is known as legal reserve ratio. It has two components. One is the Cash Reserve Ratio or CRR and the other is the SLR or Statutory Liquidity Ratio.

• Cash Reserve Ratio(CRR)-
-> It refers to the minimum percentage of total deposit of commercial bank, that t is required to keep with the central bank. Commercial banks have to keep with the central bank a certain percentage of their deposits in the form of cash reserves as a matter of law.

-> In a situation of excess demand leading to inflation,-

Cash Reserve Ratio (CRR) is raised by the Central Bank., which will reduce the cash resources of commercial bank and reducing credit availability in the economy.

It reduces purchasing power of the people.

Money supply falls in the economy.

Excess demand reduces and inflation is corrected

-> In a situation of deficient demand leading to deflation- Central bank decreases cash reserve ratio (CRR), which will increase the cash resources of commercial bank and increasing credit availability in the economy.

It increases purchasing power of the people.

Money supply rises in the economy.

Deficient demand rises and deflation is corrected.

 (vi) The Statutory Liquidity Ratio (SLR)
• It refers to minimum percentage of net total demand and time deposits, which commercial banks are required to maintain with themselves in the form of liquid assets.
• In a situation of excess demand leading to inflation-

The central bank increases statutory liquidity ratio (SLR), which will reduce the cash resources of commercial bank and reducing credit availability in the economy.

It reduces purchasing power of the people.

Money supply falls in the economy.

Excess demand reduces and inflation is corrected

 

• In a situation of deficient demand leading to deflation-

 The central bank decreases statutory liquidity ratio (SLR), which will increase the cash resources of commercial bank and increases credit availability in the economy.
It increases purchasing power of the people.

Money supply rises in the economy.

Deficient demand rises and deflation is corrected.
.

(b) Qualitative Instruments or Selective Tools of Monetary Policy: These instruments are used to regulate the direction of credit. They are as under:

(i) Imposing margin requirement on secured loans
• Business and traders get credit from commercial bank against the security of their goods. Bank never gives credit equal to the full value of the security. It always pays less value than the security.
• So, the difference between the value of security offers and value of loan asked  is called marginal requirement.
• In a situation of excess demand leading to inflation, central bank raises marginal requirements. This discourages borrowing because it makes people gets less credit against their securities.
• In a situation of deficient demand leading to deflation, central bank decreases marginal requirements. This encourages borrowing because it makes people get more credit against their securities.

(ii) Moral Suasion
• Moral suasion implies persuasion, request, informal suggestion, advice and appeal by the central banks to commercial banks to cooperate with general monetary policy of the central bank.
• In a situation of excess demand leading to inflation, it appeals for credit contraction.
• In a situation of deficient demand leading to deflation, it appeals for credit expansion.

(iii) Selective Credit Controls (SCCs)
• In this method the central bank can give directions to the commercial banks not to give credit for certain purposes or to give more credit for particular purposes or to the priority sectors.
• In a situation of excess demand leading to inflation, the central bank introduces rationing of credit in order to prevent excessive flow of credit, particularly for speculative activities. It helps to wipe off the excess demand.
• In a situation of deficient demand leading to deflation, the central bank withdraws rationing of credit and make efforts to encourage credit.