Central bank exercises monetary policy to influence rate of interest, money supply and credit availability. Central bank use different tools to achieve the objective of controlling the availability of credit in economy. There are several quantitative tools through which the central bank monitors liquidity of commercial bank and money supply. These tools help central bank to keep economy consistent. The different types of quantitative tools and Qualitative tools are as follows;
Bank rate is the interest rate at which the central bank lends loan to the commercial banks or it can also be defined as the rate at which the central bank discounts the bills of commercial banks. The difference between the bank rate and the rate of interest is that the bank rate is the rate at which central bank extends loans to the commercial banks, whereas the rate of interest is the rate at which the commercial bank extends loan to the general public.
The central bank uses the tool of bank rate to control volume of credit in an economy in such a way that when bank rate is low, the commercial banks borrow more from the central bank which increases the liquidity of commercial banks and they lend more money to the general public. While on the other hand, when bank rate is high, commercial bank borrow less from the central bank which in decreases their liquidity and they lend less loans to the general public. This is how the central bank controls credit availability through bank rate.
However, bank rate has certain limitations due to which the central bank strategy to control credit becomes less effective. Such limitations are as follows;
- All the commercial bank does not cooperate with the rules and regulations of the central bank.
- For bank rate bill market is important component, which is not well organized in the developing countries.
- The corporate sector does not distribute dividend to its shareholders and retain money in their reserves which makes them less dependent on commercial banks for capital.
According to rules set by central bank every commercial bank has to keep specific percentage of their deposits in the central bank as reserves. The central bank regulates the liquidity of commercial banks through changing the reserve ratio.
When there is inflation in an economy and more money is in circulation, the central bank increases the reserve ratio which decreases the money supply in the economy. Whereas, when there is recession in an economy the central bank decreases the reserve ration which increases the money supply in the market and the commercial become more eligible to provide more loans to the general public.
The reserve ratio has certain limitations because of which the central bank couldn’t exercise it effectively. Those limitations are as follows;
- The financial institutions such as house building societies and insurance companies provide credit to public even when central bank decreases the liquidity of commercial banks.
- Foreign banks extend loans when domestic banks decrease lending loans.
Open Market Operations
Open market operations is one of the strategies opted by the central bank for controlling credit. The central banks hold certain kinds of financial instruments like bonds and securities. Central bank regulates money supply in an economy by sale or purchase of these financial instruments. When there is inflation in the economy, the central bank sale these financial instrument and decreases the money supply in the economy. While when there is recession in an economy, the central bank purchases these financial instruments held by the general public by which money supply increases in the economy.
The policy of open market operations has certain limitations which are as follows;
- Open market operations are less effective in developing countries because they have unorganized and limited stock markets and capital markets.
- Insufficient government securities make this policy ineffective.
- When commercial banks have sufficient liquidity they become less dependent on central bank for loans.
Credit rationing refers to the limit imposed by the central bank upon commercial banks up to which they can get loans from the central bank. This is how the central bank controls the liquidity of commercial banks in order to achieve economic goals. This policy by central bank differs in inflation and recession. When there is inflation in the economy, the central bank extends fewer loans to the commercial banks. This decreases the liquidity of commercial banks. Whereas, when there is recession in the economy, the central bank extends more loans to the commercial banks which in return increase the liquidity of commercial banks.
Qualitative tools are the weapons of central bank through which the central banks monitor and control the credit availability in an economy. The qualitative tools of credit control by central bank are applicable on selective sectors of the economy. Qualitative tools have following types which are compulsorily exercised by the central bank in order to regulate money supply in the economy;
It is the strategy opted by the central bank according to which, the central bank motivates and encourage the commercial banks to get loans from it and follow its rules and regulations in return of which the central bank will support commercial bank in their favor.
The central bank publishes its quarterly annual reports which provide commercial banks feasibilities and guidelines for extending loans in different sectors of the economy. These annual reports describe all kinds of ways of increasing and decreasing the credit in various sectors of the economy to the commercial banks.