How the central bank controls money supply

Mr. Dipak Roy was visiting Kolkata with his 13 years old son. While they were walking near the administrative building, thirteen years old boy saw a big building named RBI with many security guards around it. The kid asked his father, what is that building? His father gently replied, son this is RBI, The Reserve bank of IndiaOh! a bank,.hmm..dad did we have a bank account in this bank? No son, we don’t, it’s not the bank for common people like us; this is the bank for banks. It is known as the central bank,  Mr. Roy replied.

oh!! dad, can I ask you a few questions about the central bank? I feel curious about it. Mr. Roy smiled and said, yes certainly you can ask anything you want to know about it.

What is the central bank?

A central bank is an organization which is entrusted with the task of regulating banks and other financial institutions of a country.

Why do banks need a big brother to monitor them?

It is because banks are the most important role player in the economy.

Why are the banks so much important?

It is because they give loans, take deposits and offers arrays of service to help to grow the economy of any nation.

How giving loans and accepting deposits drive the economy?

When a bank gives loans to a borrower it helps the borrower to produce more goods and services by investing in his business and it also helps the borrower to consume more than his capacity which drives growth by fueling sales volume. on the other hand, when you make deposits to the bank you earn a monthly interest which you can use to buy more goods, and the bank gives your deposited money as a loan to a borrower. when you deposit your savings to your bank account instead of stashing it into the piggy bank, your money contributes to the growth of the economy.

Is not it bad to buy goods out of borrowed money?

No. not in all cases it is bad to buy goods on borrowed money. It is bad only when you make purchases goods only for consumption purposes, but if you buy the goods for using it in your business purposes, it is good as long as you are capable of servicing your debt. You can consider borrowing money as an end consumer as long as you are capable of paying your debts on time. In this case, you should keep this in mind that you are incurring a cash outflow in terms of interest expense and principal repayment, for which you are not generating any cash inflow.

People take loans from banks. where is the central bank’s role in it?

The Central bank controls your wish to borrow in the coming months to a great extent. The Central bank also controls your feeling of wealthiness, it decides whether you will feel wealthy or poor to some extents.

Oh My God!! How can the central bank control what I feel?

The central bank regulates the interest rates at which you borrow or deposit money. It does so by increasing and decreasing interest rates with a view to balancing the money supply in the market. When the central bank increases the interest rate you tend to save money instead of borrowing because saving will yield a higher return and borrowing will cause higher interest outflow. When it increases interest rates, you do not buy comic books, bat, and video games and Xbox on EMI scheme. because you know that if you keep the money saved in banks you will earn good interest.

It happens not only with you. In the increasing trend of interest rate, everyone inclines towards savings instead of borrowing which push down the demands making goods and services cheaper than before. When the interest rate is increased, consumers gain due to price drop due to the higher interest rate but businesses suffer due to expensive loan. It is so because they have to borrow money to buy plant and machinery at higher rates which increases the cost of production. On the other hand, a high-interest rate reduces demand for goods and services, which forces businesses to sales their product at a lower price to maintain its profitability.  Increasing the interest rate shrinks the profit margin of the companies and make their business ventures unattractive. Therefore, If you are an investor you will find that your investment portfolio shrank due to the hike in interest rate. You will FEEL POORIf you are an employee you will find that your performance based perquisites drop dramatically. Increase in the interest rate, therefore, slows down all over economy resulting into the increased unemployment rate. However, the Central bank increases the interest rate when the inflation rate is higher than acceptable limits.

On the contrary, when the central bank chooses to cut the interest rates down, opposite things happen in the economy than the previous situation. A substantial rate cut floods the economy with easy money in terms of easily available credits. You will find that taking loan and spending becomes more attractive than saving into the bank account. It increases the sales, augments profit, share price rises, SIP becomes high on demand, the stock market becomes ecstatic, and the unemployment rate gets reduced due to the strong demand for labor forces.  Therefore, a lower interest rate fuels the economic growth. After a sweet interest rate cut, the price of every investment, goods, and services start to skyrocket. Your investment portfolio starts to sing romantic songs for you, and you FEEL WEALTHY. However, an interest rate cuts cause pains for fixed income earning people because their income does not rise at the pace of the price rise of essential commodities. It causes them a lot of trouble, leading to social unrest and, sometimes it becomes the key reason for the handover of political power in government.  The central bank cuts interest rates when they think that the interest rate is in acceptably low level and there is a requirement to push the economy by increasing the money supply.

Is it all a central bank does?

No, apart from influencing interest rates, the central bank uses other tools like open market operation and Quantitative easing to balance the economy for growth. A central Bank also plays a very important role in shielding the economy from global economic shocks.

About KOUSHIK DAS

I am Koushik Das, and I live in Kolkata, India. I am a passionate personal finance blogger at iplancash.com
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