INSTRUMENTS OF CREDIT

CONTROL IN CENTRAL BANK

INTRODUCTION-

The money supply is the total amount of money (currency+deposit

money) present in an economy at a particular point in time. The standard
measures to define money usually include currency in circulation and
demand deposits.

The record of the total money supply is kept by the Central Bank of the
country. The change in the supply of money in an economy can affect
the price level of securities, inflation, rates of exchange, business
policies, etc.

INSTRUMENTS ADOPTED BY THE CENTRAL BANK-

The Central Bank opt many instruments to control the credit function of
Central Bank. Such instruments are the legal power of the Central Bank.

Such legal powers are meant to control the lending capacity of

commercial banks.
It works in two ways. In performing this function the central bank tries to

influence both

1. The landing capacity of the commercial bank.

2. The demand for borrowing from these banks.

The main purpose of controlling credit creating activity of the

commercial bank is to maintain economic stability.

In other words, by controlling the money creation power of commercial

banks. The central bank can control the inflation and deflation in an

economy.

Following are the main instruments adopted by the Central Bank.

Open Market Operations:-

As we know Central Bank is the Bank of the government and financial

advisor. It has the authority to sell government securities in the open

market.

When the Central government observes an inflationary situation in the

Economy. It starts selling government securities to the general public.

Being a best trustworthy investment, the general public starts purchasing

it by issuing cheques from their demand deposit accounts with

commercial banks. The money-in-demand deposit accounts of the

commercial banks reduce. It further reduces the lending capacity of the

commercial bank.
Borrowings from bank decreases leading to decrease in the demand of

goods and services. This helps in checking inflation.

On the other hand, If Central Government observes a deflationary

situation in the Economy. It starts purchasing government securities at

an attractive price from the open market. Being a good investment deal.

General Public starts selling and deposit the money in their demand
deposit accounts with the commercial banks.

The money-in-demand deposit accounts of the commercial bank’s

increases. It further increases the lending capacity of the commercial

bank. Borrowings from bank increases leading to increase in the demand

of goods and services. This helps in checking deflation.

Cash Reserve Ratio (CRR):-

“CRR refers to that percentage of demand deposits with the commercial

banks which these banks are legally required to keep as a reserve with

the central bank.”

Suppose, the central bank wants to control the inflation in the Economy.

The Central bank can raise the CRR. Suppose the present is CRR is 10%. It
reduces the funds available for credit creation by 10%. If it is raised to

20%, available funds for landing would reduce by 20%.

Borrowings from banks decrease leading to a decrease in the demand

for goods and services. This helps in checking inflation.

On the other hand, if the central bank endeavor to control the deflation

in the Economy. It would reduce the CRR.

Suppose the present is CRR is 10%. It reduces the funds available for

credit creation by 10%. If it is reduced to 5%, available funds for landing

would increase by 5% Borrowings from bank increases leading to

increase in the demand of goods and services. This helps in checking

deflation.

Statutory Liquidity Ratio (SLR):-

“SLR refers to that percentage of deposits with the commercial bank

which these banks are legally required to keep in the form of specified

liquid assets as reserves with themselves.”

Suppose, the central bank wants to control the inflation in the Economy.

The Central bank can raise the SLR.

Suppose the present is SLR is 10%. It reduces the funds available for

credit creation by 10%. If it is raised to 20%, available funds for landing

would reduce by 20%.

Borrowings from banks decreased leading to a decrease in the demand

for goods and services. This helps in checking inflation.

On the other hand, if the central bank endeavor to control the deflation
in the Economy. It would reduce the SLR.
Suppose the present is SLR is 10%. It reduces the funds available for

credit creation by 10%. If it is reduced to 5%, available funds for landing

would increase by 5% Borrowings from bank increases leading to

increase in the demand of goods and services. This helps in checking

deflation.

Repo Rate (RR):-

“Repo rate is the interest at which the commercial banks can borrow
from the central bank to meet their short-term needs.

Suppose, the central bank wants to control the inflation in the Economy.
It would raise the Repo Rate. A higher repo rate would make the loan of

the commercial bank from the central bank Costly. This forces these
banks to raise the interest rates o lendings to the general public.

Borrowings from commercial banks become costly leading to declining

in demand for borrowings. Since borrowings decline, the spending

capacity of the people declines to lead to a fall in demand for goods and
services. This helps in checking inflation.

On the other hand, If the central bank wants to control the deflation in
the Economy. It would reduce the Repo Rate.

A low repo rate would make loans by the commercial bank from the
central bank cheap. This forces the commercial banks to reduce the

interest rates on lendings to the general public.

Borrowings from commercial banks become cheap leading to an

increase in demand for borrowings. Since borrowing increases, the

spending capacity of the people increases leading to an increase in the

demand for goods and services This helps in checking deflation.

Reverse Repo Rate (RRR):-

Reverse Repo Rate is the interest rate at which the commercial banks can

deposit their funds with the central bank.

Suppose, the central bank wants to control the inflation in the Economy.

It would raise the RRR. Higher RRR would give incentive to the
commercial banks to park their funds with the central bank. This reduces

liquidity with the commercial banks and thus lending capacity of the
bank declines.

Borrowings from banks decline to lead to low purchasing power.

subsequently, demand for goods and services declines. This helps in

checking inflation.

On the other hand, If the central bank wants to control the deflation in

the Economy. It would reduce the RRR. Low RRR discourages commercial
banks from parking their funds with the central bank rather bank

withdraws their funds from the central bank. The landing capacity of
commercial banks increases. Borrowings from commercial banks increase

leading to an increase in demand for goods and services. This helps in

checking deflation.
Bank Rate (BR):-

“Bank rate is the interest rate at which the commercial banks borrow

from the central bank to meet their long term needs.”

Suppose, the central bank wants to control the inflation in the Economy.

It would raise the Bank Rate. A higher Bank rate would make the loan of
the commercial bank from the central bank Costly. This forces these

banks to raise the interest rates on lendings to the general public.

Borrowings from commercial banks become costlier leading to decline in

demand for borrowings. Since borrowings decline, the spending capacity

of the people declines leading to a fall in demand for goods and

services. This helps in checking inflation.

On the other hand, If the central bank wants to control the deflation in

the Economy. It would reduce the Bank Rate.

A Low Bank rate would make loans by the commercial bank from the

central bank cheaper.

This forces the commercial bank to reduce the interest rates on lendings

to the general public. Borrowings from commercial banks become

cheaper leading to an increase in demand for borrowings. Since

borrowing increases, the spending capacity of the people increases

leading to an increase in the demand for goods and services This helps

in checking deflation.
Margin Requirements:-

“Margin Requirements refer to the discount fixed by the central bank on

the assets mortgaged as security by the borrowers to the commercial

banks.”

Suppose, a borrower wants to avail loan against its property worth ₹ 1

crore from commercial banks.

The margin requirement is 20%. In this case, a commercial bank is

authorized to approve only 80% loan that is ₹ 80 lakh.

Let’s suppose now the central bank wants to control the inflationary
situation in the country.

As a measure, it would increase the margin requirement as per the

situation. let’s assume it raises it to 40%.

As a result, commercial banks are now authorized to approve only 60%

of the amount of the loan against the property. It comes to around ₹ 60

lakh in cash. It would reduce the borrowing inclination among the

general public, as loans got costlier. It would reduce purchasing power

capacity, demand would decrease. As a final result, it helps in checking

inflation and vice-versa.