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

I have explain this topic in detail. Lets proceed.

Table of Contents

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 legal power of the Central Bank. Such legal powers are meant to control the landing 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 bank. 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, Central government observes a inflationary situation in the Economy. It starts selling government securities to general public.

Being a best trustworthy investment, 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 reduces. It further reduces the landing 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 banks increases. It further increases the landing 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 reserve with the central bank.”

Suppose, central bank wants to control the inflation in the Economy. The Central bank can raise the CRR. Suppose 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 bank decreased leading to decrease in the demand of 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. Higher repo rate would make loan of the commercial bank from 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 decline in demand for borrowings. Since borrowings decline, spending capacity of the people declines leading to fall in demand of goods and services. This helps in checking inflation.

On the other hand, If central bank wants to control the deflation in the Economy. It would reduce the Repo Rate. Low repo rate would make loan by the commercial bank from central bank cheap. This forces commercial bank to reduce the interest rates on lendings to the general public.

Borrowings from commercial banks become cheap leading to increase in demand for borrowings. Since borrowing increases, spending capacity of the people increases leading to increase in demand of 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 given 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 leading to low purchasing power. subsequently, demand for goods and services decline. This helps in checking inflation.

On the other hand, If central bank wants to control the deflation in the Economy. It would reduce the RRR. Low RRR discourages the commercial bank from parking their funds with the central bank rather bank withdraw their funds from central bank. The landing capacity of commercial bank increases.

Borrowings from commercial banks increases leading to increase in demand for goods and services. This helps in checking deflation.

Bank Rate (BR):-

“Bank 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 costly leading to decline in demand for borrowings. Since borrowings decline, spending capacity of the people declines leading to fall in demand of goods and services. This helps in checking inflation.

On the other hand, If central bank wants to control the deflation in the Economy. It would reduce the Bank Rate. Low Bank rate would make loan by the commercial bank from central bank cheap. This forces commercial bank to reduce the interest rates on lendings to the general public.

Borrowings from commercial banks become cheaper leading to increase in demand for borrowings. Since borrowing increases, spending capacity of the people increases leading to increase in demand of goods and services This helps in checking deflation.

Margin Requirements:-

“Margin Requirements refer to the discount fixed by the central bank on the assets mortagaged as security by the borrowers to the commercial banks.”

Margin requirements refer to the discount fixed by the central bank on the assets mortagaged as security by the government to the commercial banks.

Suppose, a borrower wants to avail loan against its property worth ₹ 1 crore from commercial banks. Margin requirement are 20%. In this case commercial banks 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 loans amount 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 further would reduce purchasing power capacity, demand would decrease. As a final result, it helps in checking inflation.

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