How Central Bank control the Money Supply class 12

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Are you looking for the answer, how does central bank control (influence) credit creation (money supply) by commercial banks as per the syllabus of economics (macroeconomics) class 12

This topic is part of the Money and Banking chapter of Macroeconomics class 12 CBSE Board.

I have explained this topic in detail. Let’s proceed.

Explain the Controller of credit function of Central Bank Class 12

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.

Read Here:- What is Money and its definition

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.

Read Here:- What is Supply of Money, its Definition and Components

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.

Read Here:- What is Central Bank and its Functions

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.

Read Here:- Explain the Money (credit) creation process by Commercial Bank

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.

Read Here:- Important MCQs of Money and Banking Chapter Class 12

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.

Read Here:- What is Money Multiplier Class 12

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.

Further Reading:-

Read Here:- Important MCQs of Money and Banking Chapter Class 12


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Anurag Pathak

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