Friday, 21 September 2012

Discuss the main instruments of monetary policy or How central bank controls the credit or Write a note on 1. open market operation 2. bank rate policy

The central bank is the controller of credit and it adopts two types of techniques, qualitative and quantitative.

These methods are used to expand or contract the total quantity of credit. These are following :

Buying and selling of Govt. bonds and securities by the central bank with a view to influence the money supply is called open market operation.

1. In Case Of Inflation :-
When the central bank finds that inflation wind is blowing which is harmful for the economy, it will try to control the credit by selling the bonds and securities in the open market. These bonds and securities will be purchased by the commercial banks or by the public. The payment will be made by the public and by the commercial banks. Cash balances of the commercial banks will be reduced and they will reduce the rate of lending. The volume of credit will be contracted. So money supply will decrease and it will reduce the rate of inflation.

2. In Case Of Deflation :-
In case of deflation central bank tries to increase the volume of credit. The central bank purchases the treasury bills and bonds. The money will move from central bank to commercial banks and to the public, i will increase the purchasing power or demand. The price level will rise and deflation will remove. The commercial banks will also lower the rate of interest will lend more money due to increase in cash balances.


1. It provides the initiative to the central bank to influence the economic activity for promoting the output and to stable the price level.

2. These instruments provide the elasticity in the economic activity.

3. The adverse fiscal policy effects can be removed.

4. This instrument is very useful for influencing the price and yield of securities.

5. This operation is also very useful for influencing the price and yield of securities.


1. Limited Scope :-
Open market operation methods is only useful in few countries like U.K, USA and Canada. While in other countries it is not useful because money market is not well organized.

2. Excess Reserves :-
If the commercial banks possess excess reserves then this policy is not useful.

3. Deficit Financing :-
A large scale deficit financing may offset the loss of cash  reserves by expanding the deposits of banks.

4. Wrong Assumption :-
It has been assumed that an increase in cash reserves of banks will lead to credit expansion and decrease in them to credit contraction, but it is not necessary that it should happen. In some developing countries this policy is hardly used for credit control.

Bank rate is the rate of interest which is charged by the central bank in providing the re-discount facility to other banks. The first class bills of exchange and Govt. securities are used for the re-discount.

Importance :-
Keep in mind bank rate is different than the market rate. If money market is well organized and economic structure is elastic a rise in discount rate followed by the rise in market rate. Discount rate is kept slightly above the market rate.


1. Rise In Bank Rate :-

When the central bank increase its discount rate. Commercial banks also increase the rate of interest. Margin of profit falls and it discourages the businessman to borrow the money. So the rate of investment, employment and output falls which leads to depression.

2. Fall In Bank Rate :-
When the bank rate is lower the commercial banks also, decrease the rate of interest, on credit. As the rate of interest falls, margin of profit will increase. It will encourage the investors to borrow and increase the rate of investment. So the volume of credit will expand. So there will be a favourable, effect on the economy.

3. Change In Discount Rate :-
The change in the discount rate affect the future market rates, such as the rates charged by the discount houses.


1.    Higher Marginal Efficiency Of Capital :-
If the marginal efficiency of capital is higher than the rate of interest then the volume of credit will expand.

2.    Rise In Prices :-
As the rate of interest increases the producer can increase the price instead curtailing the investment or borrowing.

3.    Deficit Financing :-
In case of deficit financing policy may not be applicable.

4.    Rise In Bank Rate May Rise Deposit :-
Sometimes the rise in bank rate may increase the rate of profit interest on deposits. In this way lending power of banks will rise.

5.    Lower Profit Expectations :-
During depression and falling of prices, the bank rate policy weapon is useless. During great depression of 1980 this policy failed

The amount of money which the banks are legally required to keep with central bank is called “Cash Reserve Ratio” when the ratio increases, the rate of credit contracts. When this rain falls the rate of credit expands.

It means the assets which banks are legally required to hold in the form of
1.    Cash in hand.
2.    Balances with central bank approved securities.

Credit Ceiling :-
The central bank fixes the upper limit for the credit extension for the commercial banks.

There are many weapons which are used to regulate the total supply of money and credit.
These are following :

1.    Moral Persuasion :-
The central bank can ask the commercial banks in friendly manner to follow the credit policy framed by the central bank. This method can be effective in the short period only. In this connections appeals and warnings can be issued to the commercial banks.

2.    Direct Action :-
If the commercial banks are not ready to follow the instructions of the central bank then central bank can take direct action. It can refuse to re-discount the bills of exchange, or can impose penalty.

3.    Rationing Of Credit :-
This method is used in financial crises. The credit is rationed by fixing the amount which each bank can receive by re-discounting bills of exchange.

4.    Margin Requirements On Security Plans :-

The minimum margin requirements on securities may be relaxed to encourage the borrowing and can be imposed to discourage the borrowing.

5.    Control On Consumer Credit :-
The grant of credit for consumption goods or non-essential items may be banned.

6.    Publicity :-
The central bank may convince the borrowers and the lenders through publications to adopt a specific credit policy keeping in view the nation interest.


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