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a) Quantitative Control: Through this kind of control, attempts are made by the central bank to restrict the quantity or size of credit supply. There are three quantitative instruments used by central banks. These are:

  1. Bank Rate Policy,

  2. Open Market Operations and

  3. Variable Reserve Ratios

(i) Bank Rate Policy: The Bank Rate is the official rate of interest declared by the central bank. It is that rate which the central bank charges on the rediscount facility and assistance that it provides commercial banks. The rate of interest charged by commercial banks is somewhat higher than the bank rate. Therefore whenever, the central bank lowers or raises the bank rate all other banks also have to lower or raise their respective interest rates. This makes credit or loan finance cheaper (when it is lowered) or dearer (when it is raised). This procedure helps in the expansion or the contraction of credit whenever necessary.

(ii) Open Market policy: The central bank enters the capital market and sells or buys securities to contract or expand credit supply. When securities are sold, these are purchased by individual members or by the bankers. In either case the deposits or cash reserves of the banks reduce to that extent. This diminishes the capacity of bankers to create credit and there is fall in the credit supply to the extent of some multiple of the amount of securities sold. On the other hand, when the central bank buys the security, it puts money in the hands of people or banks and it enables bankers to expand their credit supply.

The fact that the Fed can alter the composition of its Balance Sheet enables it to regulate the money supply in the economy. For instance, the Fed may want to increase the supply of money. In this case, the Fed would purchase government bonds from bondholders and private banks. The direct result of this move would be that the reserves with banks would increase by exactly that amount (by which the bonds were bought) and thus there will be an increase in the process of deposit expansion. On the other hand, the Fed may plan to decrease the amount of money supply and therefore sell the government bonds it holds. The direct result of this would be that the amount of money available to private banks for the purpose of deposit expansion (i.e. reserves) will decrease proportionately.

(iii) Variable Reserve Ratio: The central bank can also vary the cash reserves requirement of the bankers. It may be pointed out here that the money multiplier is inversely proportionate to the reserve requirement or ratio (refer the section: (C) Money Multiplier). If the reserves are increased (say from 10 to 15 percent), the money multiplier would be decreased and the capacity of the bankers to create credit will reduce to that extent. And therefore the supply of money would also decrease. But when the reserve requirement is reduced (say from 10 to 8 percent) by the central bank, the money multiplier would increase and the capacity for credit expansion would be enhanced. And hence the supply of money would also increase. This is how the Fed can control the supply of money in the economy.

b) Qualitative Credit Control: Sometimes quantitative credit control measures are inadequate or are likely to be harmful. Quantitative methods apply uniformly and to the same extent to all bankers. But if the central bank finds that only a few or specific bankers are misbehaving then it has to apply qualitative methods to individual bankers. These may be in the form of special reserve requirement, moral appeal and advise or even direct action against defaulting bankers.

(C) Money Multiplier: It has been observed in a previous section that commercial banks can make total credit supply which is a certain multiple of the original cash deposits. The extent to which such an expansion of credit can be made is called money multiplier. It is a reciprocal of the reserve requirement (which represents the tendency of people to withdraw cash). If the reserve requirement (RR) is 10 percent, the multiplier value is 10, and if RR = 8 percent, the multiplier value will be 12.5. Similarly, when RR=12 percent, the multiplier will be 8.33

Money Multiplier = 1/RR = 1/0.1 = 10, 1/0.08 = 12.6,       1/0.12 = 8.3.

Money multiplier thus varies inversely with the value of RR.

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Index

6.1 Money
6.2 Banking

Chapter 7

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