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Instruments of Monetary Control

The document discusses various instruments of monetary control used by central banks, including: 1) Bank rate policy, where the central bank sets the rate at which it lends to commercial banks. Raising this rate increases market interest rates and contracts credit in the economy. 2) Open market operations, where the central bank buys and sells government securities to improve commercial bank reserves and expand or contract credit. 3) Cash reserve ratio, where commercial banks must keep a percentage of deposits in reserves at the central bank. Increasing this ratio contracts credit. 4) Statutory liquidity ratio, where commercial banks must hold a percentage of their liabilities in liquid assets like government securities, restraining credit expansion.

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109 views

Instruments of Monetary Control

The document discusses various instruments of monetary control used by central banks, including: 1) Bank rate policy, where the central bank sets the rate at which it lends to commercial banks. Raising this rate increases market interest rates and contracts credit in the economy. 2) Open market operations, where the central bank buys and sells government securities to improve commercial bank reserves and expand or contract credit. 3) Cash reserve ratio, where commercial banks must keep a percentage of deposits in reserves at the central bank. Increasing this ratio contracts credit. 4) Statutory liquidity ratio, where commercial banks must hold a percentage of their liabilities in liquid assets like government securities, restraining credit expansion.

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snehachandan91
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© Attribution Non-Commercial (BY-NC)
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INSTRUMENTS OF MONETARY CONTROL Bank rate policy Bank rate is the rate charged by the central bank for

rediscounting first class bills of exchange and government securities held by Commercial Banks. The Bank rate policy affects the cost and availability of credit to the Commercial Banks. When there is inflation the central bank raises the bank rate. This will raise the cost of borrowing of the Commercial Banks, so they will charge a higher rate of interest on their loans and advances to the customer. This would lead to following effects: i) Rise in market rate of interest ii) Rise in the cost of borrowing money from the banks iii) Decline in demand for credit leading, to contraction of credit. When there is deflation in the economy, the central bank will lower the bank rate. Opposite trend takes place leading to expansion of credit to the economy. In short, an increase in the bank rate leads to rise in the rate of interest and contraction of credit, which in turn adversely affects investment activities and the economy as a whole. Similarly, a lowering of bank rate will have a reverse effect. When the bank rate is lowered money market rate falls. Credit becomes cheaper. People borrow, these leads to expansion of credit. This increases investment, which leads to employment and increase in production. Economy gradually progresses. In India, the bank rate has been of little significance except as an indicator of changes in the direction of credit policy and market determined through the adoption of auction procedure for treasury bills and government securities. Variations in bank rate have little significance in a scenario where hardly any rates are linked to it and the amount of refinance extended to banks at this rate is minimal. Open Market Operations The technique of open market operations as an instrument of credit control is superior to bank rate policy. The need for open market operation was felt only when the bank rate policy turned out to be a rather weak, instrument of monetary control. According to some experts, bank rate policy and open market operations are complementary measures in the area of monetary management. Open market operation is mainly related to the sale of government securities and during the busy season, they sell the securities. When commercial banks sell the securities and when RBI purchases them, The reserve position of the banks is improved and they can expand their credit to meet growing demands. Cash Reserve Ratio The commercial banks have to keep with the central bank a certain percentage of their deposits in the form of cash reserves. In India initially CRR was 5 percent. In 1962 RBI was empowered to vary it between 3 to 15 percent since then it has been increased or decreased a number of times. Increasing the CRR leads to credit contraction and reducing it will lead to credit expansion. The CRR is applicable to all scheduled banks including scheduled cooperative banks and the Regional Rural Banks (RRBs) and non scheduled banks. However, cooperative banks, RRBs, the non scheduled banks have to maintain the CRR of only 3 percent and so far it has not been changed the RBI. The CRR for both the types of Non-Resident Indians (NRI) accounts Non-Resident (External) Rupee Account (NR(E)RA) and Foreign Currency (Non-Resident Accounts (FCNRA) - was the same as for other types of deposits till 9th April 1982, the CRR for these accounts was fixed at 3 percent. Subsequently, it was raised from time to time. For example in July 1988, it was raised from 9.5 percent to 10 percent. The RBI has powers to impose penal interest rates on banks in respect of their shortfall in the prescribed CRR). CRR has been reduced to 10 percent in January

1997 and further to 8 percent (in stages of 0.25 percent per quarter over a two year period) and inter bank deposits have been exempted from April 1997. Statutory Liquidity Ratio Under the Banking Regulation Act (sec 24(2A) as amended in 1962, banks have to maintain a minimum liquid assets of 25 per cent of their demand and time liabilities in India. The Reserve Bank has, since 1970, imposed a much higher percentage of liquid assets to restrain the pace of expansion of bank credit. SLR was fixed at 31.5 percent of the net domestic and time liabilities (NDTL) on the base date 30-9-1994; and for any increase in NDTL over the level as on September 30, 1994, the SLR was fixed at 25 per cent. Inter bank deposits have been taken out of NDTL in April1997. The overall effective SLR was estimated at 28.2 per cent at the end of March 1995 and reduced to 25 per cent in October 1997.

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