For influencing the credit the central bank uses several methods which can be classified under two heads— quantitative and qualitative. The quantitative methods refer to those weapons which seek to regulate the volume of bank credit.
The important variants of quantitative methods are bank rate, open market operation and variation of the reserve ratio. The qualitative methods, on the other hand, seek to influence the distribution of credit on the basis of quality of the intending borrowers.
Assuming the volume of credit as given, these methods try to regulate the distribution of credit in such a way as to best serve the policy of the central bank and the interest of the community.
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1. Of the monetary weapons of the central bank the oldest instrument is the bank rate policy. The policy was first used in England in 1837.
Since then, despite a change in the earlier enthusiasm about its efficacy, the weapon never lost its place in the armory of central banks.
Bank rate is the minimum rate at which the central bank discounts first class bills of exchange or advance loans against approved securities. In some countries, it is primarily used to influence the level of economic activities of the community.
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The bank rate is effective as an instrument of credit control only if the market rate of interest varies with it. The association between changes in the bank rate and changes in the supply of bank money is not invariable.
Even if it is assumed that the bank rate is effective, a rise in the bank rate will have little deterrent effect on credit creation under boom conditions. Conversely, a decline of bank rate may not stimulate creation of bank money under conditions of depression.
2. Originally the open market policy was conceived as a method of enforcing the bank rate. However, afterwards, the method was freed from this dependence on the bank rate and it was accepted that it could work efficiently not only as a supplement to the bank rate but also as a substitute to it.
Open market operations mean outright purchase and sale of any security by the central bank in the open market on its own initiative. In the narrow sense, it means outright purchase and sale of only government securities on its own initiative.
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Open market operations are of two types—open market sale and open market purchase. The open market sale is mainly contractionary in its effects and is usually applied to check the evils of undesirable over-expansion of economic advised.
On the other hand, open market purchase is mainly simulative in its effect and helps recovery from the level of depression.
Open market operations are effective only if the cash reserve ratios of commercial banks are fairly rigid. A fall in the cash reserves will not lead to contraction of credit if the banks decide to keep a smaller quantity of cash as reserve.
3. The U.S.A. was the first country to introduce variable reserve ratios. Under this system every bank is required to keep with the central bank a certain percentage of its deposits. The percentage can be varied by the central bank within a certain limit prescribed by statute.
The system was adopted in India in 1956. By varying the reserve ratios the central bank can alter the cash reserves of banks and thereby control the volume of credit. When the reserve ratios are raised, banks are forced to send more cash to the central bank.
Their cash resources become less and their lending capacity is automatically reduced. When the reserve ratio is lowered, the cash resources of banks increase and they can lend more.
A small change in the reserve ratio can produce a big change in the volume of loans because commercial banks generally maintain a ratio of 10 to 16 per cent between their cash in hand and advances.
4. Selective credit controls are nowadays very effective to combat both inflation and deflation. The selective methods refer to the weapons of the central bank which put pressure only on certain strategic points of the economy without trying to regulate the total volume of credit to other sectors.
The selective methods can be distinguished from the quantitative methods, the former being interested in certain selected sectors of the economy while the latter seek to regulate the volume of credit as a whole.
The main variants of the selective methods are two—regulation of margin requirements and regulation of consumers’ credit.
The regulation of margin requirements may control the flow of credit to the selected sectors by varying the margin on borrowing against certain types of securities which the particular classes of borrowers generally use for taking loans.
The margin refers to that part of the price of the security which they cannot borrow; if Rs. 900 is borrowed against a security of Rs. 1000, the margin is 10 per cent of the value of the security. The central bank by an order may raise the margin from 10 to 50 per cent; the borrower in that case can get only Rs. 500 against the security of Rs. 1,000.
Another method of selective credit control is the consumer credit regulation. In a modern economy the level of activities in the durable consumers’ goods sector is an important determinant of the aggregate level of economic activities.
These activities are greatly dependent on the volume of consumer’s credit. The central bank may regulate the total amount of such credit by fixing the minimum down payments or the number of installments.