Central banking and monetary controls (1)

Quantitative Measures : Regulate the quantity of credit but not use of creditBank Rate Rate at which RBI lends money to domestic banking systemBank rate is the minimum rate at which the central bank of a country provides funds to commercial banksBy raising or lowering the bank rate the central bank can contract or expand the credit of the commercial banksWhen bank rate is raised , cost of borrowing by the commercial banks from the central bank goes up. This increases the lending rates of commercial banks which may compel the borrowers to borrow lessBank rate is raised when there is inflationary situation in the economy

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R B I

Functions of Central Bank

Power to Issue Notes

To act as banker’s bank

To act as bank to the govt

To act as lender of the last resort

Note Issue

 Except the issue of one rupee notes, RBI has the monopoly power to issue notes

 Before 1956, Proportional Reserve System of note issue was prevalent

 Under this system, the central bank of a country was required to maintain a certain percentage of the notes issued in the form of gold and foreign

exchange securities.

 In India, it was 40%

Minimum Reserve System

• After 1956 onwards, RBI is required to maintain a minimum value of gold and foreign exchange securities

• That minimum value is Rs 200 crores worth of Gold and Foreign

Exchange Of this, Rs 115 crores worth of gold and Rs 85 crores of foreign exchange

Banker’s Bank

• All commercial banks maintain accounts with central bank

• This facilitates settlement of claims among the banks

• Central bank plays a role of clearing house

Banker to Government

• The govt is biggest holder of funds in the country

• Central Bank usually acts as a banker to the Govt funds

• Central bank helps the govt to float the public debt and advising the govt the time it should come to the market to float the loans.

Lender of Last Resort

• Commercial banks operate on fractional reserve system

• They will be in trouble if there is sudden rush of demand for funds

• Central bank helps them during the crisis

• However, commercial banks approach central bank only as a last resort

Control of credit/ Money Supply - instruments

Central Bank controls credit or money supply with the help of various instruments such as:

• Statutory Liquidity Ratio

Mo ne

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What is Monetary Policy?

• Policy of the Monetary Authority to regulate  Money Supply

• RBI states that ‘Monetary Policy refers to the use of instruments under the control of the central bank to regulate the availability, cost and use of money and credit

• Objective of this policy is to maintain price stability

Importance of the Policy

Gross National Product (GNP) = C + I + G + X

C = Private Consumption Expenditure

I = Private Investment Expenditure

G = Government Expenditure

X = Net Exports

Monetary policy effects C, I & X

Objectives of Monetary Policy

Elements of Monetary Policy

Measures of Monetary Policy

Qualitative Measures Quantitative Measures

Open Market Operations

Cash Reserve Ratio

SLR Bank Rate

• Rationing of Credit

• Moral Suasion

• Direct Action

• Regulation of consumer credit

• Changes in margin requirements

Quantitative Measures : Regulate the quantity of credit but not use of credit

Bank Rate

• Rate at which RBI lends money to domestic banking system

• Bank rate is the minimum rate at which the central bank of a country provides funds to

commercial banks

• By raising or lowering the bank rate the central bank can contract or expand the credit of

the commercial banks

• When bank rate is raised , cost of borrowing by the commercial banks from the central

bank goes up This increases the lending rates of commercial banks which may compel the borrowers to borrow less

• Bank rate is raised when there is inflationary situation in the economy

• Repo Rate – Rate at which RBI provides loan to commercial banks RBI introduced repurchase options in 1992 on the dated govt securities When banking system experiences liquidity shortages and rate of interest is increasing , the RBI will purchase govt securities from the banks – payment

is made to banks to improve liquidity and expand credit

• Reverse Repo Rate –Since 1996 RBI introduced reverse repo to sell govt securities through auction at a fixed interest rates It will provide banks to park their surplus funds.

Cash Reserve Ratio (CRR) or (VRR ) –

• Banks in India are required to deposit a certain amount of their deposits in terms of cash with RBI This amount is called Cash Reserve Ratio (CRR)

Statutory Liquidity Ratio

• Minimum percentage of deposits the banks have to keep in the form of certain assets such

as gold, currency or other securities is called statutory liquidity ratio

Present Status of Quantitative Controls in India

Open Market Operations (OMS)

• Through OMOs, central bank either purchase or sells government bonds in the open market.

central bank purchases government securities and hence infuses money into the system

Open Market Operations

1. When central bank buys securities it pays the seller with cheque drawn upon itself

2. When this cheque is deposited with a commercial bank it’s reserves increases.

3. An increase in reserves will lead to multiple expansion of credit in the economy

4. Sale of securities by the central bank reduces the reserves of the commercial banks

5. This manner credit creation of the commercial banks can be regulated

Selective /Qualitative Credit Control Measures

• Selective methods of credit controls are used to regulate the use of credit

by discriminating the essential & non essential purposes

• RBI directs the commercial banks to meet their social obligations through selective credit controls

 Ceiling on credit - Rationing of credit is a method by which the Central Bank seeks to limit the maximum amount of loans and advances and, also in certain cases, fix ceiling for specific categories of loans and advances.

 Discriminatory rates on interest

Limitations of Monetary Policy

Non monetised sector

Non Bank financial institutions

Un Organised Financial markets

How does Monetary Policy affects Inflation

Problem : Recession & Unemployment

Solution : Expansionary Monetary Policy

Measures:

 Central Bank buys securities through open market operations

 Central Bank reduces CRR

 Lowers Bank Rate

Expansionary Monetary Policy

Money Supply Increases

Rate of Interest Falls

Investment Raises

Aggregate Increases

Aggregate output increases

Contractionary monetary policy

Problem : Inflation

Measures :

 Central bank sells securities through open market operations

 It raises CRR & SLR and Bank Rate

Contractionary Monetary Policy

Money Supply Decreases

Rate of Interest Increases

Investment decreases

Aggregate decreases

Prices fall