CBSE Class 12 Economics Chapter 4: Banking NCERT Solutions

The phenomenon where an initial deposit in the banking system leads to a multiple expansion of total deposits is known as the money multiplier or credit multiplier.

The value of the money multiplier is determined by the following formula:

$$Money\backslash \; Multiplier\; =\; \backslash frac\{1\}\{LRR\}$$

where LRR stands for the Legal Reserve Ratio.

The Legal Reserve Ratio (LRR) is the minimum ratio of deposits that commercial banks are legally required to maintain, either with themselves or with the central bank. Two specific ratios play a crucial role in determining the value of the money multiplier:

1. Cash Reserve Ratio (CRR): This is the minimum percentage of a bank's total deposits that it must hold in the form of cash reserves with the central bank (RBI).
2. Statutory Liquidity Ratio (SLR): This is the minimum percentage of net demand and time liabilities that commercial banks must maintain in the form of liquid assets, such as gold, government securities, or cash, with themselves.

A higher LRR (meaning higher CRR and/or SLR) leads to a lower money multiplier, and conversely, a lower LRR leads to a higher money multiplier.

The Reserve Bank of India (RBI) employs several instruments to manage the money supply and stabilize the economy. These are broadly classified into quantitative and qualitative instruments:

Quantitative Instruments: These affect the overall money supply and credit creation capacity of the banking system.

• Bank Rate (Discount Rate): This is the interest rate at which the central bank lends money to commercial banks without requiring any collateral.
  • To control inflation (excess demand): RBI raises the bank rate. This increases the cost of borrowing for commercial banks, forcing them to raise their lending rates. Higher lending rates discourage borrowing by businesses and consumers, reducing investment and consumption, thus curbing excess demand.
  • To control deflation (deficient demand): RBI decreases the bank rate. This lowers the cost of borrowing for commercial banks, enabling them to reduce their lending rates. Lower lending rates encourage borrowing, boosting investment and consumption, thus mitigating deficient demand.
• Repo Rate: The rate at which commercial banks borrow funds from the RBI by selling securities with an agreement to repurchase them at a later date. An increase in the repo rate makes borrowing costlier for banks, leading to higher lending rates and reduced credit availability, thus controlling inflation. A decrease has the opposite effect.
• Reverse Repo Rate: The rate at which the RBI borrows funds from commercial banks. An increase in the reverse repo rate encourages banks to park more funds with the RBI, reducing liquidity in the banking system and helping to control inflation.
• Open Market Operations (OMO): This involves the buying and selling of government securities and bonds in the open market by the RBI.
  • To control inflation: RBI sells government securities. Commercial banks purchase these, which reduces their cash reserves and lending capacity, thereby controlling excess demand.
  • To control deflation: RBI purchases government securities from commercial banks. This injects liquidity into the banking system, increasing their cash reserves and lending capacity, thereby stimulating demand.
• Varying Reserve Requirements:
  • Cash Reserve Ratio (CRR): The percentage of deposits banks must hold with the RBI. An increase in CRR reduces the lendable funds of banks, contracting the money supply. A decrease has the opposite effect.
  • Statutory Liquidity Ratio (SLR): The percentage of deposits banks must hold in liquid assets. An increase in SLR reduces the funds available for lending, contracting the money supply. A decrease has the opposite effect.

Qualitative Instruments: These selectively influence credit distribution.

• Imposing Margin Requirement on Secured Loans: This is the difference between the value of the security offered for a loan and the actual loan amount granted.
  • To control inflation: RBI raises the margin requirement. This means borrowers get less credit against their securities, discouraging borrowing and curbing excess demand.
  • To control deflation: RBI decreases the margin requirement. This allows borrowers to get more credit against their securities, encouraging borrowing and stimulating demand.
• Moral Suasion: This involves the RBI persuading commercial banks to adopt certain policies or refrain from certain actions, often through informal discussions and appeals.
• Selective Credit Controls (SCCs): These are used to control credit flow to specific sectors or for specific purposes, often to prevent speculative activities.

By skillfully using these instruments, the RBI can manage the money supply to stabilize the economy against fluctuations like inflation and deflation caused by exogenous shocks.