Question

Define or Explain the following concepts.

1. Prof. Samuelson's definition of Central Bank
2. Open Market Operation
3. Bank Rate
4. Moral suasion
5. Cash Reserve Ratio
6. Clearing House System
7. Central Bank as Bank of Issue

Answer 1

1. According to Prof. Samuelson “Central Bank is a bank of bankers. Its duty is to control the monetary base, through the control of high powered money, to control the community's supply of money.”

2. Open Market Operations refer to the buying and selling of government securities. These securities can be bought or sold to the public or to the commercial banks in an open market. Open Market Operations are used by the Central Bank to affect the money supply in the economy. The selling of securities by the RBI wipes out the extra cash balance from the economy, thereby limiting the money supply, whereas in the case of buying securities by the RBI, additional money is pumped into the economy stimulating the money supply.

3. Bank Rate refers to the rate of interest at which the Central Bank lends money to the commercial banks or the rate at which the Central Bank discounts the bills of the commercial banks. This rate is also called the rediscount rate. This instrument is a key in the hands of RBI to control money supply. Change in the bank rate changes the cost of borrowings, thereby affecting money supply. An increase in the bank rate increases the cost of borrowing for the commercial banks from the Central Bank. The commercial banks, in turn, increase the lending rate for their customers. However, this increase in the lending rate reduces the borrowing capacity of the public, thereby discouraging loans and credit.

4. A persuasion technique followed by the central bank to pressurise the commercial banks to abide by the monetary policy is termed as moral suasion. This involves meetings, seminars, speeches and discussions, which explain the present economic scenario and thereby persuade the commercial banks to adapt the changes needed.

5. CRR or the Cash Reserve Ratio refers to the minimum amount of funds that a commercial bank has to maintain with the Reserve Bank of India, in the form of deposits. CRR is used to affect the lending capacity of the commercial banks. An increase in the CRR reduces the money left with the commercial bank for lending eventually leading to a decrease in the money supply.

6. All the commercial banks are mandatorily required to keep a certain percentage of their deposits, other than cash reserve ratio (CRR), with the Central Bank. The Central Bank acts as a clearing house for the commercial banks. As a clearing house, it settles inter-bank claims and reduces the need for cash reserves by the commercial banks.

7. The Central Bank is the sole entity that can print currency notes. In other words, the central bank of a country has the exclusive authority to issue the currency (notes + coins). The currency issued by the central bank is known as 'legal tender money' i.e. the value of such currency is backed by the central bank. Since, issuance of notes is exclusively reserved for the Central bank, it is said to be the ‘Bank of Issue’.