PathSet Publications
MEASURES TO CONTROL EXCESS DEMAND
We can control the excess demand with the help of the following policy:
(1) Monetary Policy
(2) Fiscal Policy
(a) Monetary Policy: Monetary policy is the policy of the central bank of a county to control money supply and availability of credit in the economy. The central bank can take the following steps:
1. Quantitative Instruments or General Tools of Monetary Policy: These are the instruments of monetary policy that affect overall supply of money/credit in the economy. These instruments do not direct or restrict the flow of credit to some specific sectors of the economy. They are as under:
Bank Rate or Discount Rate (Increase in Bank Rate)
Bank rate is the rate of interest at which central bank lends to commercial banks without any collateral (security for purpose of loan). The thing, which has to be remembered, is that central bank lends to commercial banks and not to public.
In a situation of excess demand leading to inflation.
Central bank raises bank rate that discourages commercial banks in borrowing from central bank, as it will increase the cost of borrowing of commercial bank.
It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans, which discourages investment.
Again high rate of interest induces households to increase their savings by restricting expenditure on consumption.
Thus, expenditure on investment and consumption is reduced, which will control the excess demand.
Repo Rate (Increase in Repo Rate):
Repo rate is the rate at which commercial banks borrow money from the central bank for short period by selling their financial securities to the central bank.
These securities are pledged as a security for the loans.
It is called Repurchase rate as this involves commercial bank selling securities to RBI to borrow the money with an agreement to repurchase them at a later date and at a predetermined price.
Therefore, keeping securities and borrowing is repo rate.
In a situation of excess demand leading to inflation, Central bank raises repo rate that discourages commercial banks in borrowing from central bank, as it will increase the cost of borrowing of commercial bank.
It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans, which discourages investment.
Again high rate of interest induces households to increase their savings by restricting expenditure on consumption.
Thus, expenditure on investment and consumption is reduced, which will control the excess demand.
Reverse Repo Rate (Increase in Reverse Repo Rate):
It is the rate at which the central bank (RBI) borrows money from commercial bank.
In a situation of excess demand leading to inflation, Reverse repo rate is increased, it encourages the commercial bank to park their funds with the central bank to earn higher return on idle cash. It decreases the lending capability of commercial banks, which controls excess demand.
Open Market Operations (OMO) (Sale of securities):
It consists of buying and selling of government securities and bonds in the open market by central bank.
In a situation of excess demand leading to inflation, central bank sells government securities and bonds to commercial bank. With the sale of these securities, the power of commercial bank of giving loans decreases, which will control excess demand.
Increase in Varying Reserve Requirements or Legal Reserve Ratio:
Banks are obliged to maintain reserves with the central bank, which is known as legal reserve ratio. It has two components. One is the Cash Reserve Ratio or CRR and the other is the SLR or Statutory Liquidity Ratio.
Cash Reserve Ratio (Increase in CRR):
It refers to the minimum percentage of a bank’s total deposits, which
it is required to keep with the central bank. Commercial banks have to keep with the central bank a certain percentage of their deposits in the form of cash reserves as a matter of law.
For example, if the minimum reserve ratio is 10% and total deposits of a certain bank is Rs.100 crore, it will have to keep Rs.10 crore with the central bank.
In a situation of excess demand leading to inflation, cash reserve ratio (CRR) is raised to 20 percent. The bank will have to keep Rs.20 crore with the central bank, which will reduce the cash resources of commercial bank and reducing credit availability in the economy, which will control excess demand.
Statutory Liquidity Ratio (Increase SLR):
It refers to minimum percentage of net total demand and time liabilities, which commercial banks are required to maintain with themselves.
In a situation of excess demand leading to inflation, the central bank increases statutory liquidity ratio (SLR), which will reduce the cash resources of commercial bank and reducing credit availability in the economy.
2. Qualitative Instruments or Selective Tools of Monetary Policy:
These instruments are used to regulate the direction of credit. They are as under:
Imposing margin requirement on secured loans (Increase):
Business and traders get credit from commercial bank against the security of their goods. Bank never gives credit equal to the full value of the security. It always pays less value than the security.
Therefore, the difference between the value of security and value of loan is called marginal requirement.
In a situation of excess demand leading to inflation, central bank raises marginal requirements. This discourages borrowing because it makes people get less credit against their securities.
Moral Suasion:
Moral suasion implies persuasion, request, informal suggestion, advice and appeal by the central banks to commercial banks to cooperate with general monetary policy of the central bank.
In a situation of excess demand leading to inflation, it appeals for credit contraction.
Selective Credit Control (SCC) [Introduce Credit Rationing]:
In this method, the central bank can give directions to the commercial banks not to give credit for certain purposes or to give more credit for particular purposes or to the priority sectors.
In a situation of excess demand leading to inflation, the central bank introduces rationing of credit in order to prevent excessive flow of credit, particularly for speculative activities. It helps to wipe off the excess demand.
(b) Fiscal Policy: The expenditure and revenue policy taken by the general government to accomplish the desired goals is known as fiscal policy. A general government can take the following steps:
Revenue Policy (Increase Taxes):
Revenue policy is expressed in terms of taxes.
During inflation the government impose higher amount of taxes causing the decrease in purchasing power of the people.
It is so because to control excess demand we have to reduce the amount of liquidity from the economy.
Expenditure Policy (Reduces Expenditure):
Government has to invest huge amount on public works like roads, buildings, irrigation works, etc.
During inflation, government should curtail (reduce) its expenditure on public works like roads, buildings, irrigation works thereby reducing the money income of the people and their demand for goods and services.
Increase in Public Borrowing/Public Debt:
This measure means that government should raise loans from public and hence borrowing decreases the purchasing power of people by leaving them with lesser amount of money.
Therefore, government should resort to more public borrowing during excessive demand.
Government should make long term debts more attractive so that public may use their excess liquidity amount of money in purchasing these bonds, which will reduce the liquidity amount of money in the economy and thereby inflation could be controlled
Measures to Control the deficient demand:
We can control the deficient demand with the help of the following policies:
(a) Monetary policy
(b) Fiscal policy
Monetary Policy: Monetary policy is the policy of the central bank of a country of controlling money supply and availability of credit in the economy. The central bank takes the following steps:
1. Quantitative Instruments or General Tools of Monetary Policy: These are the instruments of monetary policy that affect overall supply of money/credit in the economy. These instruments do not direct or restrict the flow of credit to some specific sectors of the economy. They are as under:
Bank Rate or Discount Rate (Decrease in Bank Rate):
Bank rate is the rate of interest at which central bank lends to commercial banks without any collateral (security for purpose of loan). The thing, which has to be remembered, is that central bank lends to commercial banks and not to public.
In a situation of deficient demand leading to deflation, Central bank decreases bank rate that encourages commercial banks in borrowing from central bank as it will decrease the cost of borrowing of commercial bank.
Decrease in bank rate makes commercial bank to decrease their lending rates, which encourages borrowers from taking loans, which encourages investment.
Again low rate of interest induces households to decrease their savings by increasing expenditure on consumption.
Thus, expenditure on investment and consumption increase, which will control the deficient demand.
Repo Rate (Decrease Repo Rate):
Repo rate is the rate at which commercial banks borrow money from the central bank for short period by selling their financial securities to the central bank.
These securities are pledged as a security for the loans.
It is called Repurchase rate as this involves commercial bank selling securities to RBI to borrow the money with an agreement to repurchase them at a later date and at a predetermined price.
Therefore, keeping securities and borrowing is repo rate.
In a situation of deficient demand leading to deflation, Central bank decreases Repo rate that encourages commercial banks in borrowing from central bank, as it will decrease the cost of borrowing of commercial bank.
Decrease in Repo rate makes commercial banks to decrease their lending rates, which encourages borrowers from taking loans, which encourages investment.
Again low rate of interest induces households to decrease their savings by increasing expenditure on consumption.
Thus, expenditure on investment and consumption increase, which will control the deficient demand.
Reverse Repo Rate (Decrease Reverse Repo Rate):
It is the rate at which the central bank (RBI) borrows money from commercial bank.
In a situation of deficient demand leading to deflation, Reverse repo rate is decreased, it discourages the commercial bank to park their funds with the central bank. It increases the lending capability of commercial banks, which controls deficient demand.
Open Market Operation (Purchase of Securities):
It consists of buying and selling of government securities and bonds in the open market by central bank.
In a situation of deficient demand leading to deflation, central bank purchases government securities and bonds from commercial bank. With the purchase of these securities, the power of commercial bank of giving loans increases, which will control deficient demand.
Decrease in Varying Reserve Requirements:
Banks are obliged to maintain reserves with the central bank, which is known as legal reserve ratio. It has two components. One is the Cash Reserve Ratio or CRR and the other is the SLR or Statutory Liquidity Ratio.
Cash Reserve Ratio (Decrease):
It refers to the minimum percentage of a bank’s total deposits, which is required to keep with the central bank. Commercial banks have to keep with the central bank a certain percentage of their deposits in the form of cash reserves as a matter of law.
For example, if the minimum reserve ratio is 10% and total deposits of a certain bank is Rs. 100 crore, it will have to keep Rs.10 crore with the central bank.
In a situation of deficient demand leading to deflation, cash reserve ratio (CRR) falls to 5 percent, the bank will have to keep Rs. 5 crore with the central bank, which will increase the cash resources of commercial bank and increasing credit availability in the economy, which will control deficient demand.
The Statutory Liquidity Ratio (SLR) (Increase):
It refers to minimum percentage of net total demand and time liabilities, which commercial banks are required to maintain with themselves.
In a situation of deficient demand leading to deflation, the central bank decreases statutory liquidity ratio (SLR), which will increase the cash resources of commercial bank and increases credit availability in the economy.
2. Qualitative Instruments or Selective Tools of Monetary Policy: These
instruments are used to regulate the direction of credit. They are as under:
Imposing margin requirement on secured loans (Decrease):
Business and traders get credit from commercial bank against the security of their goods. Bank never gives credit equal to the full value of the security. It always pays less value than the security.
Therefore, the difference between the value of security and value of loan is called marginal requirement.
In a situation of deficient demand leading to deflation, central bank decreases marginal requirements. This encourages borrowing because it makes people get more credit against their securities.
Moral Suasion:
Moral suasion implies persuasion, request, informal suggestion, advice and appeal by the central banks to commercial banks to cooperate with general monetary policy of the central bank.
In a situation of deficient demand leading to deflation, it appeals for credit expansion.
Selective Credit Controls (SCCs):
In this method, the central bank can give directions to the commercial banks not to give credit for certain purposes or to give more credit for particular purposes or to the priority sectors.
In a situation of deficient demand leading to deflation, the central bank withdraws rationing of credit and make efforts to encourage credit.
(b) Fiscal Policy: The expenditure and revenue policy taken by the general government to accomplish the desired goals is known as fiscal policy. A general government has to take the following steps:
Revenue Policy (Decrease in Taxes):
Revenue policy is expressed in terms of taxes.
During deflation, the government will impose lower amount of taxes so that purchasing power of the people be increased.
It is so because to control deficient demand we have to increase the amount of liquidity in the economy.
Expenditure Policy (Increase in Expenditure):
Government has to invest huge amount on public works like roads, buildings, irrigation works, etc.
During deflation, government should increase its expenditure on public works like roads, buildings, irrigation works thereby increasing the money income of the people and their demand for goods and services.
Decrease in Public Borrowing / Public Debt:
At the time of deficient demand, public borrowing should be reduced.
People will have more money and more purchasing power.
In brief, during period of deficient demand government should adopt the pricing of deficit budget.
Old taken debts from public should be finished and paid back to increase money in the market.
