Question

Answer the following question.
Explain the "varying reserve requirements" method of credit control by the central bank. 

Answer 1

1. Bank Rate: Bank rate refers to the rate at which the central bank provides loans to commercial banks. This instrument is a key at the hands of RBI to control the money supply. Changes in the bank rate change the cost of borrowings, thereby affect the money supply. This is explained by the following mechanism.
To summarise,
Bank rate ↑ ⇒ cost of borrowing for the commercial bank ↑ ⇒ lending rate for the public ↑ ⇒ Borrowing capacity ↓⇒ demand for loans and credit ↓⇒ money supply ↓

Bank rate ↓ ⇒ cost of borrowing for the commercial bank ↓ ⇒ lending rate for the public ↓ ⇒ Borrowing capacity ↑ ⇒ demand for loans and credit ↑ ⇒ money supply ↑

2. Cash reserve ratio (CRR)- It refers to the minimum proportion of the total deposits that the commercial banks have to maintain with the central bank in the form of reserves. 
To summarise,

CRR ↑ ⇒ Deposits with the bank's ↓ ⇒ cash reserves of the bank ↓ ⇒ Lending capacity of the bank's ↓ ⇒ Money supply ↓ 

CRR ↓ ⇒ Deposits with the bank's ↑ ⇒ cash reserves of the bank ↑ ⇒ Lending capacity of the bank's ↑ ⇒ Money supply ↑

3. Statutory Liquidity Ratio (SLR): Statutory Liquidity Ration (SLR) is defined as the minimum percentage of assets to be maintained by the commercial banks with themselves in the form of either fixed or liquid assets. The flow of credit is reduced by increasing this liquidity ratio and vice-versa.
SLR ↑ ⇒ Minimum percentage of assets ↑ ⇒ Lending capacity of the bank's ↓ ⇒ Money supply ↓

SLR ↓ ⇒ Minimum percentage of assets ↓⇒ Lending capacity of the bank's ↑ ⇒ Money supply ↑