Quantitative (General) Methods of Credit Control

Quantitative methods affect the total volume of credit in the whole economy. The three classic quantitative tools are the bank rate, open market operations, and the cash reserve ratio (CRR). In modern practice the RBI also uses the statutory liquidity ratio (SLR) and the repo and reverse-repo rates, which work on the same principle.

1. Bank Rate (Discount Rate)

The bank rate is the rate of interest at which the central bank lends money to, or rediscounts the eligible bills of, commercial banks.

• When the RBI raises the bank rate, borrowing from the RBI becomes costlier for commercial banks. Banks in turn raise their own lending rates, loans become dearer, borrowing by the public falls, and credit contracts. This is done to control inflation.
• When the RBI lowers the bank rate, borrowing becomes cheaper, banks lower their lending rates, loans become cheaper, borrowing rises, and credit expands. This is done to fight deflation/recession.

2. Open Market Operations (OMO)

Open market operations mean the buying and selling of government securities (bonds and bills) by the central bank in the open market.

• To contract credit (control inflation), the RBI sells securities. Buyers pay with cheques drawn on their banks, so cash flows out of the banks to the RBI, banks' reserves fall, and their power to create credit shrinks.
• To expand credit (fight recession), the RBI buys securities. It pays the sellers, cash flows into the banking system, banks' reserves rise, and their power to create credit grows.

3. Cash Reserve Ratio (CRR)

The cash reserve ratio is the minimum percentage of a bank's total deposits that it must keep as cash reserves with the RBI.

• When the RBI raises the CRR, banks must keep a larger share of deposits with the RBI, leaving them less to lend; credit contracts (controls inflation).
• When the RBI lowers the CRR, banks are free to keep less with the RBI and lend more; credit expands (fights recession).

Because banks create credit as a multiple of their reserves, even a small change in the CRR has a large effect on total credit. The credit multiplier is 1 divided by the CRR — so at a CRR of 20% (0.20) each rupee of primary deposit can support up to 1 / 0.20 = 5 rupees of total deposits.

4. Statutory Liquidity Ratio (SLR) (related tool)

Every bank must also keep a minimum percentage of its deposits with itself in the form of liquid assets — cash, gold, and approved government securities. Raising the SLR reduces the funds available for lending (contracts credit); lowering it does the opposite.

5. Repo and Reverse Repo Rates (modern tools)

The repo rate is the rate at which banks borrow short-term funds from the RBI against securities; the reverse repo rate is the rate at which the RBI borrows from banks. Raising the repo rate makes such borrowing costlier and contracts credit; lowering it expands credit. …