Monetary measures to control inflation
The main methods of controlling the credit creating capacity of banks are as follows: —
(i) Manipulating the bank rate, i.e., the rate at which the central bank is willing to rediscount the eligible paper offered by the commercial banks. A rise in the bank rate will be followed by a rise in other money market rates of interest. There will be an all-round hardening of the rates of interest. A rise in the rate of interest will tend to reduce the amount of aggregate spending for the following reasons: —
(a) Borrowing becomes more costly than before. The potential borrowers will, therefore, postpone their investment plans. They would like to wait till interest rates fall to their more normal level. A cut in investment will usually mean a reduction in the volume of spending and thereby help moderate the inflationary pressures.
(b) An increase in the rate of interest has some adverse psychological effects on the business confidence. In a way, it is a red signal to the businessmen that bad times are ahead. This by itself will help to dampen their enthusiasm for a rational spending on investment.
(c) An increase in the rate of interest may make saving more attractive than before so that some people will be tempted to consume less of their income than before. This will reduce consumers' spending.
(ii) Manipulating credit-creating capacity of banks. The other method is that of attacking directly the credit-creating capacity of banks. We know that in their own interest, banks do want to keep a minimum reserve of cash which bears more or less a definite relationship to the volume of their deposits. If the central bank of the country can reduce the cash available to the banking system, the capacity of the bank to lend money to the borrowers will be reduced. The banks, therefore, in their own interest will be induced to contract the supply of credit. The borrowers now, not being able to get help from the banks as easily as previously, will be forced to postpone their investment plans. The various methods of controlling the credit-creating capacity of banks are: —
(a). Open market operations. If the central bank wants to reduce the credit-creating capacity of commercial banks, it will sell government securities to the public or the banks themselves. Either way, the result will be that the amount of cash with the banks will diminish and this will force them to reduce the supply of credit.
(b) Varying percentage of cash reserves held by commercial banks. The
Same effect may be brought about by varying cash ratios, in countries where the commercial banks are required to keep certain minimum cash in relation to the volume of their deposits and the central bank or the government has the power to change these ratios from time to time. When it is desired to reduce the credit created by commercial banks, the cash ratios can be raised, so that for a given amount of deposits the banks now need to keep higher cash reserves than before. This will exercise a contractionist effect on bank credit.
Monetary policy, however, is not, without its limitations, the chief among them are as under:—
(i) The effectiveness of monetary measures depends on the co-operation between the commercial banks and the central bank. A boost in bank rate may be fruitless if commercial banks don’t follow the increase in the bank rate by increasing their individual interest rates. Where there is no tradition of close co-operation between the central bank and commercial banks, or where the central bank has no legal powers to force the commercial banks to fall in line, this difficulty will prove a great limitation on the effectiveness of monetary policy.
(ii) Even if the rates of interest do rise, they may not be capable of curbing spending considerably. For example, if the prospects of profits are very good, businessmen do not mind paying a slightly higher rate of interest on their borrowings. Further, investment is increasingly being financed out of undistributed profits so that the dependence of firms on banks for funds has been greatly reduced. Therefore, a change in interest rate may not disturb very much the plans for investment.
(iii) As regards the efficacy of open market functions as a curb on the lending activity of banks, their success depends on the existence of a viable, broad-based market in government securities; otherwise open market operations even on a minor scale will exercise a greatly destabilizing influence on the prices of government securities and will hamper the efficient conduct of government's borrowing operations.
(iv) A major difficulty, particularly in under-developed countries, arises from the fact that the central bank has often not enough control over all the banks. In our own country, the organized banking sector which is easily amenable to control by the central bank is very small. The aboriginal bankers and the rural community money-lenders, who do the bulk of the business of lending in the rural areas, are beyond the control of the Reserve Bank.