Q. 21

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Answer :

The central bank is the apex bank which has the sole authority to control all the commercial banks and financial institution in the economy. When the central bank controls all the financial institutions in the economy, it is also vested with the function of credit control in the c-economy. It is one of the most important functions of the central bank in the economy. The central bank has many tools which are used to control the credit in the economy. They are

a. Reserve ratios such as Cash Reserve Ratio, Statutory liquidity ratio,

b. Bank rate

c. Open market operation

d. Margin requirements

e. Moral suasion etc.

Reverse repo rate

Reverse repo rate is the rate at which the central bank of a country borrows money from commercial banks within the country. It is a monetary policy instrument which can be used to control the money supply in the country. The reverse repo rate is the method of quantitative credit control method used by the central bank. Credit control methods are being used to control the inflation and deflation that is occurred in the economy. When the economy faces the inflation then the central bank will borrow from the commercial banks. Thus the ability of the commercial banks to lend loans is reduced. This reduces the money supply in the economy.

Open market operation

The open market operation is the method of quantitative credit control method used by the central bank. This method refers to the sale and purchase of securities, bills and bonds of the government as well as private financial institution by the central bank. Credit control methods are being used to control the inflation and deflation that is occurred in the economy. When the economy faces the inflation then central bank sells the government securities. While the securities are being sold to the public, money supply in the economy can be reduced. The money supply is reduced by reducing the liquid money that is held with the public.


Money supply is determined by the central bank of the country. Money supply is defined as the sum of its constituent asset. The money supply is the amount available in the economy. Money supply includes both currencies in hands of the public and demand deposit at the bank. Therefore the liquid definition of the money supply is Currency + demand deposit + other deposit.

M= C+DD+OD; where M is money supply, C is Currency, DD is Demand deposit and OD is other deposit.

The value of money supply changes when these components changes. There are three determinants of the money supply. They are cash reserve ratio, excess reserves of commercial bank and public's currency holding.

Commercial banks play a very important role in the process of credit creation. The process of 'Credit Creation' begins with banks lending money out of deposits that are accepted by the people. Deposits are those deposits which are deposited in banks; these deposits include the demand deposit and other deposit. Since banks cannot lend the entire deposits as they are required to maintain a certain proportion of primary deposits in the form of reserves with the RBI under RBI & Banking Regulation Act. That reserve which is maintained with RBI is known as cash reserve ratio. After maintaining the required reserves, the bank can lend the remaining portion of deposits.

It can be explained by the following numerical example:

When the individual ‘X' deposits the money into his bank say Rs 100. The bank is liable to return the deposit to the ‘X's on his demand and that type of deposit is known as a demand deposit. Assuming the all the bank customers will not withdraw their entire deposit at a time bank, the bank will lend the amount to other individuals after holding an amount as a reserve with both RBI and Bank itself. Assume that reserve is 10%, then the bank will hold Rs 10 and lend remaining Rs 90 to another person ‘Y’ for the interest. The loan amount will be credited to his bank account.

The deposited loan amount to ‘Y’s bank account will not be withdrawn all at a time. Y will spend the amount which is needed and save the amount in the account. The bank will further lend the amount keeping the reserve amount 10% that is Rs 9 and lend the remaining Rs81 to another person ‘Z’ for interest. The same process will continue till the reserve of the commercial banks becomes zero. This process of credit creation is illustrated in a table:

This table process continues till the reserves of the commercial bank become zero. Within the 4th round, the total amount of credit created is 309.7Rs with the initial deposit of the 100Rs. Therefore the credit creation process depends on the reserve ratios. When the reserves ratios are lower, higher will be the credit creation process and when the reserves are higher, then the credit creation will be lower.

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