Quantitative Instruments of Monetary Policy
Quantitative Instruments:
It is called quantitative, as they regulate the total quantity of money. In this category, the tools are –
Bank Rate or Discount Rate
Open Market Operation
Minimum Reserve Requirements
Bank Rate or Discount Rate:
It is the oldest method of credit control. It was used by the Bank of England in 1839. Bank rate refers to the rate of interest at which the Central Bank rediscounts approved bills of exchange. I used as instrument with the assumption that market rate of interest respond to the change in bank rate. When bank rate is raised, this is called a dear money policy, where as when bank rate is reduced this is called as cheap money policy. When bank rate is raised the market rate of interest will increase and vice versa.
Let us understand this in detail. Money held by commercial bank is called reserve. If these reserves are kept idle, then the returns are nil. Commercial bank tries to keep their reserve as low as possible. In doing so, they run the risk of running below the Reserve requirement level. In such cases, they sell the securities in their possessions and deposit the proceeding at Central Bank or directly sell it to central bank. So, whenever commercial banks are in need the central bank lends reserves directly to the banks for a charge known as bank rte or discount rate.
Open Market Operation:
It refers to purchase or sale by Central Bank of any securities, to regulate the credit creating capacity of Commercial Bank. Whenever the Central Bank purchases the securities, it does payment by cheque to sellers. The seller with deposit it with the Commercial Bank and the bank reserve increases. This is done when the central bank wants to increase the money supply in the economy. When the reserves with the Commercial Bank increases, the loan giving capacity of commercial Bank increases. On the other hand, Central Bank will sell the securities and accept cheque payments by the people who will be depositing the cheques in Commercial Bank. This leads to decrease in the reserve with commercial bank; as a result the loan giving capacity will decrease.
Minimum Reserve Requirement:
Every Commercial Bank has to maintain certain amount of reserve with Central Bank. Central bank has the power to set the reserve requirement to control the lending capacity of Commercial Banks. By changing the reserve requirement, it can control the money supply. Reserve maintained by commercial bank is called Statutory Reserve and the reserve over and above the Statutory Reserve is called ‘Excess Reserve’.
Excess reserve = total reserve – statutory reserve
Statutory Liquidity Requirement (SLR) is the minimum amount of liquid assets maintained by the banks, which is equal to or not less than a specific percentage of outstanding deposit liabilities.
Cash Reserve Ratio (CRR):
Commercial Bank has to keep a deposit with the Central Bank. This amount of funds is equal to specific percentage of its own deposit liabilities. This is Cash Reserve Ratio. These reserve requirements of central bank work as a very strong weapon and cause sharp change in lending capacity of commercial bank.
Overall, the chapter has been dealt in the continuation of Monetary Policy.
