Policy Tools to Control Money Supply

Reserve Bank is the only establishment which can issue currency. When commercial banks require more funds in order to be able to create more credits, they may go to market place for such funds or go to the Central Bank. Central bank furnishes them funds through diverse instruments. This part of RBI, that of being ready to lend to banks at all times is another significant function of the central bank and due to this central bank is said to be the lender of last resort.

The RBI regulates the money supply in the economy in various ways :

  • The tools utilised by the Central bank to control money supply can be quantitative or qualitative
  • Quantitative tools, regulate the expanse of money supply by changing the CRR or bank rate or open market functions
  • Qualitative tools comprise encouragement by the Central bank in order to make commercial banks discourage or encourage lending which is done through moral suasion, margin requisite etc.,

It should be apparent by now that if the Central bank changes the reserve ratio, this would head to changes in lending by the banks which, in turn, would influence the deposits and therefore, the money supply. In the previously discussed example, what would the money multiplier be if the Reserve Bank of India increases the reserve ratio to 25%? Note that in the previous scenario, Rs.100 in reserves could support deposits of Rs. 400. However, the banking structure would now be able to loan Rs.300 only. It would have to call back some loans to meet the raised reserve demands. Therefore, money supply would come down.

Another significant tool by which the RBI also impacts money supply is Open Market Operations. Open Market Operations refers to purchasing and selling of bonds issued by the Government in the open market place. This buying and selling is endowed to the Central bank on behalf of the Government. When RBI buys a Government bond in the open market, it incurs the payment for it by giving a cheque. This cheque rises the total amount of reserves in the economy and hence, increases the money supply. Selling of a bond by RBI (to private individuals or establishments) heads towards depletion in the amount of reserves and therefore, the money supply.

There are 2 types of open market operations :

  • Outright
  • Repo

Outright open market operations are perpetual in nature: when the central bank purchases these securities (thus injecting money into the structure), it is without any promise to sell them later. Likewise, when the central bank sells these securities (thus withdrawing money from the structure), it is without any promise to purchase them later. As an outcome, the administration/incorporation of the money is of perpetual nature. However, there is another type of function in which when the central bank purchases the security, this agreement of purchase also has statement about the date and price of resale of this security. This type of agreement is called as repurchase agreement or repo.

The above mentioned is the concept that is explained in detail about Policy Tools to Control Money Supply. To know more, stay tuned to BYJU’S.