Instrument of Monetary Policy

The methods of regulating volume of credit and money supply by the central bank are called monetary policy instruments. These are discussed below:

• Bank Rate Policy. Bank Rate is that rate at which the central bank lends to commercial banks. The deposit as well as lending rates of banks are related to the bank rate. Thus, when credit needs to be contracted, bank rate is raised, the lending rates of commercial banks also go up. Borrowings by people become costly and hence less loans are wanted. Credit thus gets contracted. When credit needs to be expanded, the bank rate is reduced.
• Repo Rate and Reverse Repo Rate. The RBI uses these instruments for regulating money supply in India. Repo rate is the rate of Interest that RBI charges for lending short-term funds to the banks when RBI raises repo rate, borrowings from the RBI by the banks becomes costlier. So they raise their own lending rates to the public. This reduces public borrowings from the banks and thus reduces credit and money supply in the market.
• Open Market Operations. The government sells securities in the market and collects money, which reduces money supply with the public as well as the banks. Thus, they can create less credit. When credit needs to be expanded government’s securities. Increase in banks’ resources enable them to create more credit.
• Changing the Cash Reserve Ratio (CRR). This is the proportion of their total deposits which the banks are required to keep with the central bank, when CRR is raised, more money goes to central bank and less is left with the banks for credit creation. Reduction is CRR has the opposite effects.
• Changing the Statutory Liquidity Ratio (SLR). The banks are under legal obligation to keep a certain proportion of its total deposits in liquid assets. These liquid assets consists of (a) cash reserves with the banks themselves, (b) cash reserve with the central bank under CRR, (c) Investment in government securities and (d)deposits with other banks. Supposing this ratio is 25 to 30 per cent by the central bank. The banks will now have 5 per cent less funds for lending. This will reduce credit. If SLR is reduced from 25 per cent to 20 per cent, the banks will have more funds to lend and thus create more credit and add to money supply.
• Changing Margin Requirement. When marginal requirements are raised, it means people get less money against a given security. This naturally discourages borrowings. When marginal requirements are reduced, more money is borrowed by people and thus more credit created.
• Moral Suasion. This is the moral pressure of the central bank on the other banks to make suitable changes in the volume of credit as desire by it.
• Direct Action. Warnings, penalties, etc., for not implementing central bank’s policy constitute direct action.