Policy Tools to Control Money Supply

The Reserve Bank of India is the only establishment that can issue currency in India. When commercial banks require more funds in order to be able to create more credits, they may go to the marketplace for such funds or go to the central bank. 

The central bank provides them funds through diverse instruments. This function of the RBI to lend to banks at all times is another significant function of the central bank and due to this, the 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 the money supply can be quantitative or qualitative.
  •     Quantitative tools regulate the expanse of the money supply by changing the CRR, 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, and more.

Now, we know that if the central bank changes the reserve ratio, this will lead to changes in lending by the banks which would influence the deposits and therefore, the money supply. In the previous 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 out Rs. 300 only. It would have to call back some loans to meet the raised reserve demands. Therefore, the money supply would come down.

Another significant tool by which the RBI also impacts the money supply is open market operations. Open market operations refer to the purchasing and selling of bonds issued by the government in the open marketplace. This buying and selling are endowed to the central bank on behalf of the government. When the RBI buys a government bond in the open market, it incurs the payment for it by giving a cheque. 

This cheque raises 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) results in depletion in the number of reserves and therefore, the money supply.

There are two 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, where when the central bank purchases the security, this agreement of purchase also has a statement about the date and price of the resale of this security. This type of agreement is known as a repurchase agreement or repo.

This article is about the policy tools that are used to control money supply. To learn more, stay tuned to our website.

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