Question

Explain how controlling money supply is helpful in reducing excess demand.

Answer 1

Excess demand can be reduced by using the following instruments to control the money supply:-

1. Cash Reserve Ratio (CRR) is the necessary minimum percentage of a bank’s total deposits which is to be kept with the Central Bank. Commercial banks need to maintain with the Central Bank a certain percentage of their deposits in the form of cash reserves. The Central Bank can vary CRR between 3% and 15%. When they hold a large portion of their deposits as CRR, it reduces the provision of credit to the public. This leads to a decline in the demand for loans and consumption expenditure. Thus, the aggregate demand comes down and the economy attains equilibrium.

2. The Central Bank increases the bank rate and there is an increase in the cost of borrowing for commercial banks. This enables the decrease for the demand for loans and borrowings in the market. This in turn decreases the ability to purchase more. In this way, the aggregate demand decreases to the level of aggregate supply and the economy attains equilibrium.

3. The repo rate will be increased by the Central Bank and it will increase the cost of borrowings for the commercial bank. This leads to a decline in the demand for loans and consumption expenditure. Thus, the aggregate demand comes down and the economy attains equilibrium.

4. Reduction of margin money requirements is a measure which induces borrowers to avail more loans from commercial banks. This in turn increases the ability to purchase more. In this way, the aggregate demand increases to the level of aggregate supply and the economy attains equilibrium.