Today, in this article we will discuss few tools that are widely used by central banks across the world to regulate the economy of a country and managing inflation. These tools are used to create temporary demands in the market as well as to facilitate the export competitiveness of a country. In the modern economic scenario, the most used weapons in the armory of central banks are interest rate and CRR. We will start our discussion first with interest rate and thereafter we will discuss the effect of CRR on the economy.
Interest rate and its effect:
The interest rate cut by central bank means it pumps more money into the system by way of cheap loan. It makes saving unattractive because people do not like to save money in term deposits or fixed deposits when the interest rate is low. Instead of saving, people like to buy goods like a car, house, electronic gadgets etc. Thus, a rate cut increases demand of commodities and services. It also augments equity market investment. A rate cut generally increases the price of banking companies shares immediately and other companies follow thereafter. A rate cut generally makes a bull run in the stock market. However, on the other hand, a rate cut causes inflation due to a sudden increase in demand resulting in demand and supply mismatch.
Inflation is a condition which leads to price rise and reduction of purchasing power of a currency. In simple word, inflation is a situation where more money is rushing behind a commodity than before. Suppose commodity x got a price tag of $5 and there is 10 unit in demand and 10 unit in supply. Suddenly, the demand for the commodity became 12 unit but the supply is still the same because production capacity cannot be enhanced instantly after a certain limit. now 12 buyers are rushing to get this 10 unit commodity which will inflate the price upward at $6(assumed) which eventually reduce the purchasing capacity of the dollar.
On the other hand, an increase in interest rate leads to lower money supply into the system leading to increase in the cost of debt which results in less consumption and more saving. It also hampers growth perspective because it slows down capital expenditure by corporate houses. Generally, central bank tightens interest rates when there is significant inflation in the economy.
CRR or cash reserve ratio:
CRR or cash reserve ratio is a certain percentage of net demand and time liability, in the form of a liquid asset such as money, gold etc. needs to be kept as a deposit with the central bank(RBI or Federal Reserve) by a bank. The CRR is mandated by the central bank to ensure sufficient liquidity remains with the bank to meet any sudden outflow. The percentage rate of CRR is specified by the Central Bank on time to time.
When inflation is lower and other financial conditions are stable RBI lowers this percentage rate which allows the bank to spend more money on giving loans to customers. It injects more money into the system which stimulates growth as well as push inflation to a higher level. On the other hand, when the inflation rate is high, RBI increases CRR rate to pump out money from the system to check the inflation rate under control.
The Central bank also uses govt. bonds to control the liquidity of the market. When inflation is soaring high Central bank sells bonds in the open market which reduces money into the system and in contrary when inflation is low or country is in deflationary situation central bank issues(buys) bond to pump liquidity. This is commonly known as open market operation.