The most important function of the Central Bank is to control credit. The Central Bank uses various methods to control credit. This method can be classified into two broad categories. They are: Methods of Credit Controls
1. Bank rate policy
2. Open market operations
3. Variation of cash reserve ratio
4. 'Repo' or Repurchase Transactions
1. Fixation of margin requirements
2. Rationing of credit
3. Regulation of consumer credit
4. Controls through directives
5. Moral suasion
7. Direct action
Quantitative Methods of Credit Control
The quantitative methods of credit control are the general and traditional methods. They aim at the regulation of the quantity of credit and not its application in various uses. They are expected to control and adjust the total quantity of deposits created by the commercial banks. They relate to the volume in general. These methods are indirect in nature. The objectives of quantitative methods of credit control are as follows: (i) Controlling the volume of credit in the economy.
(ii) Maintaining equilibrium between saving and investment in the economy. (iii) Maintaining the stability in exchange rates.
(iv) Correcting disequilibrium in the balance of payments of the country. (v) Removing shortage of money in the money market.
The important methods under this category are, 1. Bank Rate Policy It is also known as discount rate policy. Bank rate is the rate at which the Central Bank is prepared to rediscount the approved bills or to lend on eligible paper. This weapon can be used independently or along with other weapon. By changing this rate the Central Bank control the volume of credit. The bank rate is raised in times of inflation and is lowered in times of deflation. A rise in the bank rate is usually preceded by the following events: (i) Over supply of money and rising price level.
(ii) Great demand for money caused by active trade.
(iii) Adverse rate of exchange, and
(iv) Unfavorable balance of trade.
In times of adverse balance of payments and rising price level, the Central Bank increases the bank rate and thereby forces the market rates to go up. Because of this, credit becomes dear and borrowing from banks becomes costly. The speculators are discouraged to buy and stock goods. They start selling their stock of goods in the market, and the prices take a downward trend. Exports begin to rise and the imports decline. Foreign investors are encouraged to keep their cash balances within the county so as to earn the increased rate of interest. The adverse balance of payments gradually disappears. A rise in bank rate has the following consequences:
There is a corresponding rise in the market rate that is, the rate charged by financial institution. The prices of fixed interest bearing securities tend to register a decline because the interest rate ruling in the market would be higher than the rate originally fixed on such securities. A shift in investments from fixed interest bearing securities to equities results in a rise in the prices of the latter, especially, shares of growing companies. There is shrinkage in investment on capital assets due to the shortage of finances. Fall in the prices of consumer commodities due to less spending and the unloading of stocks. Transference of foreign money into the country due to the high rates of interest ruling and the consequent improvement in the foreign exchange position. Increase in exports.
But in times of falling prices, the Central Bank lowers the bank rate and brings about a fall in the market rates of interest. This will lead to increased volume of trade, investment, production and employment and ultimately leads to the rise in the price level. Conditions for the Operation of Bank Rate Policy
To use the weapon of bank rate policy some basic requirements are to be fulfilled. The impact of a change in the Bank rate depends...