Question

Answer the following question.
Elaborate any two instruments of Credit Control, as exercised by the Reserve Bank of India.

Answer 1

The following are the instruments of Credit Control by RBI:

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.
An increase in the bank rate increases the cost of borrowing for commercial banks from the central bank. The commercial banks, in turn, increase the lending rate for their customers. However, this increase in the lending rate reduces the borrowing capacity of the public, thereby, discourages loans and credit. This depresses the multiplier process and thus, decreases the value of money multiplier. Hence, the total money supply decreases. A decrease in the bank rate will have the reverse effect and will increase the 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.
An increase in the CRR would mean that banks would be required to keep a greater portion in the form of deposits with the central bank. This implies that commercial banks are left with a lesser amount of funds to lend out. Hence, the lending capacity of the banks reduces, leading to a fall in the money supply. On the contrary, a fall in CRR will lead to an increase in the money supply.

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 ↑