Question

Explain the instruments of monetary policy.

Answer 1

1. Bank rate: The bank rate is the rate at which the central bank lends money to commercial banks or discounts their approved bills. By adjusting the bank rate, the central bank can influence credit availability and the money supply in the economy. When the bank rate is increased, the interest rates in the economy go up, making borrowing more expensive. This is usually done during inflation to reduce excess spending. A higher bank rate reduces the ability of commercial banks to lend, as they have fewer reserves, which limits credit expansion. On the other hand, when there is a depression, the central bank lowers the bank rate. This makes borrowing cheaper, encouraging the business sector to take more loans, which helps boost investment and demand, pulling the economy out of a slowdown. So, the bank rate is a powerful tool that can be used to manage both inflation and depression.
2. Open market operations: Open Market Operations refer to the buying or selling of government securities by the central bank to control the money supply in the economy. The ability of commercial banks to create credit depends on the amount of cash reserves they hold. So, by influencing these reserves, the central bank can control the level of credit in the economy. During inflation, to reduce excess money in circulation, the central bank sells securities in the open market. People buy these by withdrawing money from their bank accounts, which reduces banks' reserves and limits their capacity to give loans. This helps in controlling inflation. During depression, when prices and demand are low, the central bank buys securities. This puts more money into people's hands and increases the cash reserves of banks, allowing them to lend more. As a result, credit, demand, and prices rise, helping the economy recover.
3. Change in liquidity: Under this method, commercial banks are required to keep a specific portion of their deposits in cash or other easily liquidated assets. This is known as the liquid ratio. When the central bank wants to reduce credit in the economy, it increases the required liquid ratio, forcing banks to hold more cash and lend less. On the other hand, to expand credit, the central bank lowers the liquid ratio, allowing banks to have more funds available for lending. In short, the liquid ratio is the fixed percentage of a bank’s total assets that must be maintained in the form of cash or other liquid assets.
4. Change in market requirements: In this method, the central bank adjusts the margin requirements to either restrict or encourage the availability of credit. When the central bank observes that prices are rising due to traders hoarding goods, it can increase the margin requirement to reduce credit. The margin requirement is the difference between the market value of a pledged asset and the amount of loan that can be taken against it. For example, if a borrower pledges goods worth ₹1,000 and the margin is 20%, the bank will give a loan of ₹800. If the margin is increased, the borrower will need to pledge more valuable goods to get the same loan amount. This discourages borrowing, reduces money supply, and helps control inflation. On the other hand, during a depression, the central bank may lower margin requirements. This allows borrowers to get loans more easily, encouraging spending and boosting economic activity. So, changing margin requirements is a useful tool for the central bank to manage both inflation and depression.
5. Regulation of consumer credit: To control excessive consumer spending during inflation, the central bank restricts certain credit-based buying options, like hire-purchase or installment plans. By limiting these facilities, people are discouraged from making unnecessary purchases, helping to reduce demand and control inflation. In contrast, during a depression, the central bank encourages credit facilities. This makes it easier for consumers to buy goods on credit, increasing spending and helping to revive demand in the economy.
6. Direct action: This method is used when certain commercial banks do not follow the central bank’s credit control guidelines. In such cases, the central bank takes strict action directly against those banks.
   1. It may deny rediscounting facilities to banks that disobey its instructions.
   2. It can refuse support to banks that request funds beyond their capital and reserve limits.
   3. The central bank may charge a higher interest rate (penal rate) than the usual bank rate.
   4. It can also impose stricter rules or penalties on the defaulting bank.
7. Rationing of credit: In this method, the central bank sets a limit on the credit that commercial banks can access. As the lender of last resort, the central bank distributes the available credit carefully among different applicants. Generally, rationing of credit is done by the following four ways:
   1. The central bank may deny loans to certain banks.
   2. It may reduce the loan amount granted to a bank.
   3. It can set credit quotas, restricting how much a bank can borrow.
   4. It may also set limits on loans given to specific industries or sectors.