Question

Explain how controlling money supply is helpful in reducing excess demand.

Answer 1

The following are the various monetary policy instruments that the central bank uses to combat excess demand:
(i) Bank rate policy: Bank rate is the rate charged by the Central bank on its loans that it advances to a commercial bank against the securities. When Central bank needs to expand the credit then Bank rate is decreased and when it is needed to contract the credit, bank rate is increased. It directly affects the loan giving ability of the central bank. It is the easiest way of credit control.
(ii) Open market operations: Open market operations refer to the buying and selling of government securities by the central bank from the public or banks. When government wants to contract credit, the central banks start selling securities to the commercial banks, and when they want to expand credit, the central bank starts buying the securities. Buying the securities results in more money with the banks and they have more capability to advance loans. Similarly, selling the securities to the bank leaves them with less cash reserves, by which they become less capable for advancing loans.
(iii) Change in (CRR) Cash Reserve Ratio: Under CRR, the banks are required to deposit with the central bank a percentage of their net demand and time liabilities in the form of liquidity or cash. Banks reduce the percentage of deposits if they want to expand the credit, and they raise the percentage if they want to contract the credit.
(iv) Change in (SLR) Statutory Liquidity Ratio: The SLR requires the banks to maintain a specified percentage of their net total demand and time liabilities in the form of designated liquid assets with itself.