Question -
Answer -
1. Principal instruments of Monetary Policy or credit control of the Central Bank of a country(RBI) are broadly classified as:
(a) Quantitative Instruments,
• Bank Rate
• Repo rate
• Reverse Repo rate
• Open Market Operations (OMO)
• Varying Reserve Requirements (fa) Qualitative Instruments
• Imposing margin requirement on secured loans
• Moral Suasion
• Selective Credit Controls (SCCs)
2. RBI stabilize money supply against exogenous shocks in the following manner:
(a) Bank Rate (Discount Rate)
• Bank rate is the rate of interest at which central bank lends to commercial banks without any collateral (security for purpose of loan). The thing, which has to be remembered, is that central bank lends to commercial banks and not to general public.
• In a situation of excess demand leading to inflation,
> Central bank raises bank rate that discourages commercial banks in borrowing from central bank as it will increase the cost of borrowing of commercial bank.
> It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans, which discourages investment.
> Again high rate of interest induces households to increase their savings by restricting expenditure on consumption.
> Thus, expenditure on investment and consumption is reduced, which will control the excess demand.
• In a situation of deficient demand leading to deflation,
> Central bank decreases bank rate that encourages commercial banks in borrowing from central bank as it will decrease the cost of borrowing of commercial bank.
> Decrease in bank rate makes commercial bank to decrease their lending rates, which encourages borrowers from taking loans, which encourages investment.
> Again low rate of interest induces households to decrease their savings by increasing expenditure on consumption.
> Thus, expenditure on investment and consumption increase, which will control the deficient demand.
(b) Open Market Operations (OMO)
• It consists of buying and selling of government securities and bonds in the open market by central bank.
• In a situation of excess demand leading to inflation, central bank sells government securities and bonds to commercial bank. With the sale of these securities, the power of commercial bank of giving loans decreases, which will control excess demand.
• In a situation of deficient demand leading to deflation, central bank purchases government securities and bonds from commercial bank. With the purchase of these securities, the power of commercial bank of giving loans increases, which will control deficient demand.
(c) Imposing margin requirement on secured loans
• Business and traders get credit from commercial bank against the security of their goods. Bank never gives credit equal to the full value of the security. It always pays less value than the security.
• So, the difference between the value of security and value of loan is called marginal requirement.
• In a situation of excess demand leading to inflation, central bank raises marginal requirements. This
discourages borrowing because it makes people gets less credit against their securities.
• In a situation of deficient demand leading to deflation, central bank decreases marginal requirements. This encourages borrowing because it makes people get more credit against their securities.
(d) Moral Suasion
• Moral suasion implies persuasion, request, informal suggestion, advice and appeal by the central banks to commercial banks to cooperate with general monetary policy of the central bank.
• In a situation of excess demand leading to inflation, it appeals for credit contraction.
• In a situation of deficient demand leading to deflation, it appeals for credit expansion.