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Policy Tools to Control Money Supply

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  • Last Updated : 29 Sep, 2021

India’s central monetary authority is the Reservespan Bank of India. Every year in April, the Reserve Bank of India announces its monetary policy. Generally, in a year three quarterly reviews are done by RBI in July, October, and January. The RBI’s monetary policy covers a wide range of issues, including financial markets, interest rates, financial stability, loan delivery, regulatory standards, financial inclusion, etc. Monetary policy refers to a set of activities aimed at controlling the circulation of money in the economy with the general goal of maintaining economic and financial stability, as well as ensuring enough financial resources for development. These monetary policy objectives in India have evolved through time and may now be broadened to include preserving price stability, appropriate credit flow to productive sectors, encouragement of productive investments and trade, promotion of exports, and economic growth.

The RBI established a statutory and institutionalized structure for a Monetary Policy Committee to preserve price stability while also pursuing growth. Out of six members of the Monetary Policy Committee, Three members are from the RBI, while the other three will be nominated by the Central Government, according to the RBI Act 1934.

There are some tools through which the RBI can control the money supply:

REPO RATE AND REVERSE REPO RATE: Repo is a transaction in which the RBI sells securities and then buys them back at a set price. This set price is calculated in relation to the repo rate, which is an interest rate. The higher the repo rate, the more expensive funds are for banks, and hence the higher the rate that banks pass on to their consumers. A high rate indicates that banks’ access to money is prohibitively expensive. As a result, less credit will flow into the system, reducing the liquidity of an economy. Banks use the reverse repo rate to deposit excess cash with the RBI. While the repo rate helps to manage short-term capital, the reverse repo rate attempts to lower the total money supply of an economy.

The cost of borrowing and lending for banks will rise as the repo rate rises, discouraging the people from borrowing and encouraging them to deposit, thus it will reduce the money supply from the economy.

CASH RESERVES RATIO (CRR): This is the proportion of a bank’s total deposit that the RBI requires to be maintained in cash. The central bank can set a limit on the ratio. A high CRR indicates banks have less money to lend, reducing liquidity; a low CRR has the reverse effect. Depending on the situation, the RBI can alter the CRR to tighten or release liquidity. CRR stands at 4% at the moment. The CRR is being raised by the central bank, reducing the amount of loanable money available to banks. As a result, investment slows and the supply of money in the economy shrinks.

The smaller the liquidity in the system, the higher the CRR with the RBI. The RBI has the authority to change the CRR between 15% and 3%. According to the recommendations of the Narasimham Committee report, the CRR was cut from 15% in 1990 to 5% in 2002. 

BANK RATE: The RBI offers banks a re-discounting rate on assets like as bills of exchange, commercial papers, and other recognized securities. The repo rate, rather than the bank rate, has served as a guideline for banks in setting interest rates in recent years. The bank rate moves in the same direction as the repo rate.

When banks are able to borrow from the central bank at a cheaper rate, they pass the savings on to their clients by lowering the cost of loans. Higher interest rates encourage lending, resulting in a reduction in the amount of money in circulation.

STATUTORY LIQUIDITY RATIO: This is the amount of money that banks must invest in government-approved securities as a proportion of their overall deposits. The lower the SLR, the more banks are forced to lend outside. When the SLR rises, it limits the bank’s lending ability and aids in inflation control by sucking liquidity from the market. As a result, banks will have less money to lend and, in order to maintain their profit margins.

These assets must be maintained in non-cash forms including G-secs, precious metals, and approved securities such as bonds. The Statutory Liquidity Ratio is the ratio of liquid assets to time and demand liabilities. Because of the Narsimham Committee’s recommendation, the SLR was reduced from 38.5 percent to 25%. The SLR is now at 18 percent as of October 9, 2020.

OPERATIONS IN THE OPEN MARKET: The central bank regulates the short-term money supply by purchasing and selling government securities. To regulate the flow of credit, the RBI sells government securities. The RBI uses this technique to control liquidity on a regular basis, even when it is not conducting a monetary policy review.

Apart from supplying commercial banks with liquidity and occasionally withdrawing surplus liquidity from commercial banks, the main goal of open market operations is to influence the short-term interest rate and the supply of base money in an economy, and therefore indirectly regulate the overall money supply.

SUASION OF MORALITY: The Reserve Bank of India (RBI) uses this as a qualitative instrument of monetary policy, (unlike SLR or CRR) which includes psychological means and informal means of selective credit control. . By this RBI can ask commercial banks to take specific actions and steps in response to particular economic trends. The Reserve Bank of India may ask commercial banks to refrain from lending for unproductive reasons that do not contribute to economic growth but instead raise inflation.

Conclusion:

One of the major roles of Central banks is to make sure that a country’s economy is must be in good shape. One way central banks achieve this goal is by controlling the amount of money flowing through the economy. Influencing interest rates, establishing reserve requirements, and utilizing open market operating methods are just a few of their weapons. It is critical to have the proper amount of money in circulation in order to maintain a stable and healthy economy.

These are monetary policy’s numerous chosen instruments. However, the availability of alternative sources of credit in the economy, the activities of Non-Banking Financial Institutions (NBFIs), the profit motivation of commercial banks, and the undemocratic character of these instruments restrict their success. However, the intended objectives can be achieved by using a combination of both general and selective monetary policy instruments.

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