MONEY SUPPLY CONTROL - LIQUIDITY CONTROL - CREDIT CONTROL - INFLATION CONTROL

Reserve Bank of India (RBI) has to manage Money Supply all the time because money position determines level of inflation and level of growth of the country. RBI always strives to maintain optimum level of money supply so that inflation is not at high level and growth is also not affected. As such, RBI makes various credit policies and uses various tools for controlling credit / money supply / liquidity to further control inflation.

These control or change in credit policies is done through Monetary Policy Committee (MPC) which meets BI-monthly. MPC always check the position of money supply and other factors in the market and accordingly make credit policies.

Liquidity, money supply, Inflation and other expectation are managed or controlled through Credit Control measures which is broadly Classified into two categories: Quantitative Control and Qualitative Control.

Quantitative Control

Bank accepts deposits from public and lend to borrower which lead to increase money supply so there are measure by which Quantum of money supply can be controlled which is called Quantitative credit Control and finally control inflation.

Under Quantitative Control RBI follow two policy- Interest rate policy and Ratio policy

Interest Rate Policy

Making credit costly through increasing interest rate leads to fall in demand for credit and take away the money supply from the economy. However, if credit cost becomes cheaper, the demand for credit rise and money supply increases and in turn give rise to inflation.

These can be elaborated further through banking system: On day to day banking operation, banks usually face two situations, either Shortage of fund or Surplus of fund.

In above situation, in order to maintain adequate liquidity, banks borrow / lend fund under two operations Repurchase Option (REPO) and Reverse REPO under Liquidity Adjustment Facility (LAF) provided by RBI.

Repurchase Option (REPO)

In case of shortage of fund on a particular day, banks avail fund from RBI and in turn provide Government Securities / Debt Securities to RBI at pre-determined rate with an option that they will get back their Securities upon refund of borrowed money back to RBI.

The REPO option under Liquidity Adjustment facility is used when bank is having surplus securities after maintaining Stipulated Securities as reserve under Statutory Liquidity Ratio.

When RBI reduces Repo rate, banks will get fund at low cost, the benefit of which banks pass on to their borrowers by way of low lending rate that results in increase in money supply and encourages demand for credit.

In case RBI increases REPO rate it implies that credit will become costlier which result in sucking of money supply from the economy and discourages demand for credit.

Marginal Standing Facility (MSF)

However, when Banks do not have Surplus Securities over and above Securities required under SLR and is also short of fund then banks opt for Marginal Standing Facility (MSF) provided by RBI, where Bank can borrow by dipping into SLR securities but rate of interest charged under MSF is higher than interest charged under LAF

Reverse REPO

In case of surplus of fund on a particular day, banks park that fund with RBI against Government Securities / Debt Securities at pre-determined rate with an option to repurchase it when money is refunded back to banks. This way bank generates interest income on their idle fund.

RBI, by reducing Reverse REPO rate, encourages banks to lend more to public instead of parking excess funds with RBI and increases the flow of money supply in the system.

In reverse situation, by increasing Reverse REPO rate, RBI discourage lending to public and suck money supply from the system by enabling banks to park their excess funds with RBI.

RATIO POLICY

Another control measure under Quantitative Credit Control is Ratio Policy i.e. by managing certain ratio, like Cash Reserve Ratio and Statutory Liquidity Ratio, money supply can be increase or decrease.

Cash Reserve Ratio (CRR)

In CRR, Commercial Banks have to keep certain percentage of Net demand and time liabilities (NDTL) as cash reserve with RBI.

Hence, if RBI will reduce the CRR requirement, bank will have to keep less reserve with RBI which means more money in the hand of banks for lending.

For example: Suppose Bank A has NDTL of Rs.100 cr and need to keep CRR of 4% it means bank can lend up to Rs.96 cr [Rs.100 Cr. - (4% of Rs.100 Cr.)]

Then next month, say RBI reduced the CRR to 3%. It means now bank can lend up to Rs.97 cr [Rs.100 Cr. - (3% of Rs.100 Cr.)]

This shown by reducing CRR by 1% bank has Rs.1 Cr. more money in their hand which they can lend and in vice versa situation money supply can be suck by increasing CRR, thereby funds available for lending with the banks decrease.

Statutory Liquidity Ratio (SLR)

In addition to CRR, banks also need to maintain Statutory Liquidity Ratio where banks need to invest a certain percentage of banks’ net demand and time liabilities in government approved securities with themselves as reserve.

If SLR increases, then banks have to keep investing more in the approved securities to keep it as reserve and as such low money supply available in the hand of banks for lending.

On the other hand, money supply can be increase by reducing the SLR requirement by RBI.

Selective Credit Control under Qualitative Control is the 2^nd method used by RBI to manage money supply and control inflation.

Qualitative Control - Selective Credit Control

It is generally seen that prices are rising in one area faster than other areas. For example: Production of Oil seed is less and demand is more, as such price of oil is rising. People buy and start holding it which further depicts less production and results in price rise. As such, supply of credit to some segments need to be controlled.

If supply of credit to particular segment will be controlled, then money supply in that segment will come down and in turn holding capacity will come down automatically, thereby curbing inflation of that goods.

In order to manage price and inflation, Credit Control are used and since it is used for essential or selective items like wheat, rice, pulses, vegetables oil it is called Selective Credit Control.

RBI uses two tools under Selective Credit Control: Margin and Interest Rate

Margin

By adjusting margin i.e. by increasing margin of Credit the money supply can be restricted.

Say out of Rs.100 Cr. if 25% margin is required then in that case Rs.75 cr (75% of Rs.100 cr) can be financed as such one can hold more goods and due to which price will rise.

However, if above margin will increase from 25% to 50% that means borrower needs to bring more fund as their contribution to hold the same quantity of goods. This way by increasing margin of Credit for selected items, money supply is controlled and price rise can be controlled

Interest Rate

Interest rate is another effective tool for increase / reduced credit demand. Higher interest rate discourages demand for credit. If people have less money, this reduces their holding capacity and price of goods will automatically be controlled. The moment capacity to buy goods reduces and leads to de-holding of goods, the price will stabilize.

So, this way price of goods of particular segment is controlled through Selective Credit Control