Question

Write short notes on:

1. Definition of a Central Bank
2. Issuing Directives
3. Central Bank's measure of regulation of consumer credit
4. Regulation of Margin Requirements
5. Cash Reserve Ratio (CRR)
6. Bank Rate
7. Open Market Operations (OMO)

Answer 1

1. The Central Bank is the apex institution of a country's monetary system. It regulates and controls the activities of all the commercial banks and other financial institutions of the country. It plays a pivotal role in the organisation and development of a sound monetary and financial system in an economy. In India, the Reserve Bank of India (RBI) is the central bank.
The following are some of the definitions of central bank.
According to Prof. Paul. A Samuelson “Central bank is a bank of bankers. It’s duty is to control the monetary base and through the control of high powered money to control the community’s supply of money”
According to Prof. Hawtrey “ Central Bank is that which the lender of last resort”

2. Issuing Directives is another qualitative measure of credit control used by the Central Bank. Under this method, the Central Bank issues directives or orders that must be followed by the public and the commercial banks. This is done to ensure that the credit policy followed by the Central bank is consistent with the monetary policy followed by the commercial banks.

3. Consumer credit refers to the credit that is used by the consumers to buy consumer durable goods such as laptops, mobiles, cars etc. An increase in the amount of this credit will lead to an increase in the demand for goods. With the production of goods remaining unchanged, this increase in demand will result in a shortage of goods. Similarly, a decrease in the amount of this credit will result in decrease in the demand for goods, causing supplies to remain unsold. Thus, the Central Bank's measure of regulation of consumer credit is used to regulate the amount of consumer credit that can be granted to ensure that the production or inventories are not affected.

4. Margin requirement implies ascertaining the value of the loan that can be granted upon the mortgage of a certain security. The banks keep a margin, which is the difference between the market value of a security and its loan value. For example, a commercial bank grants loan of Rs 80,000 against security of Rs 1,00,000. So, the margin is calculated as Rs 1, 00,000 – Rs 80,000 = Rs 20,000. A rise in the margin requirement discourages loans. Accordingly, when the central bank decides to restrict the flow of money, then the margin requirement of loan is raised. This is referred to as ‘Regulation of Margin Requirements’.

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. For example, suppose the total assets of a bank are worth Rs.200 Crores and the minimum cash reserve ratio is 10%, the amount that the commercial bank has to maintain with RBI is Rs.20 Crores. If this ratio rises to 20%, the reserve with RBI increases to Rs.40 Crores. Thus, less money will be left with the commercial bank for lending. This will eventually lead to considerable decrease in the money supply.

6. 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 the RBI to control money supply. Increase in the bank rate will make the loans more expensive for the commercial banks and thereby, pressurise the banks to increase the rate of lending. The public capacity to take credit will gradually fall leading to a fall in the volume of credit demanded.

7. 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 money supply in the economy. The selling of securities by the RBI will wipe out the extra cash balance from the economy, thereby limiting the money supply, whereas in the case of buying securities by RBI, additional money is pumped into the economy stimulating money supply.