Role of central Bank in Money Market

Last updated on December 5th, 2019 at 12:27 pm

Firstly the central bank (RBI) could do this by setting a necessary reserve ratio, which would restrict the ability of the commercial banks to increase the money supply by loaning out money. If this condition were above the ratio the commercial banks would have wished to have then the banks will have to create fewer deposits and make fewer loans then they could otherwise have profitably done. If the central bank imposed this requirement in order to reduce the money supply, the commercial banks will probably be unable to borrow from the central bank in order to increase their cash reserves if they wished to make further loans. They might try to attract further deposits from customers by raising their interest rates but the central bank may retaliate by increasing the necessary reserve ratio.

The central bank(RBI) can influence the supply of money through special deposits. These are deposits at the central bank which the banking sector is required to lodge. These are then frozen, thus preventing the sector from accessing them even though interest is paid at the average Treasury bill rate. Making these special deposits reduces the level of the ‘commercial banks’ operational deposits which forces them to cut back on lending.

The supply of money can also be prohibited by the central bank(RBI) by adjusting its interest rate which it charges when the commercial banks wish to borrow money (the discount rate). Banks generally have a ratio of cash to deposits which they consider to be the minimum safe level. If command for cash is such that their reserves fall below this level they will able to borrow money from the central bank at its discount rate. If market rates were 8% and the discount rate were also 8%, then the banks might decrease their cash reserves to their minimum ratio knowing that if demand exceeds supply they will be able to borrow at 8%. The central bank, even if, may raise its discount rate to a value above the market level, in order to encourage banks not to reduce their cash reserves to the minimum during excess loans. By raising the discount value to such a level, the commercial banks are given an incentive to hold more reserves thus reducing the money multiplier and the money supply.

Another way the money supply can be affected by the central bank is through its operation of the interest rate. By raising or lowering interest rates the demand for money is respectively reduced or increased. If it sets them at a certain level it can clear the market at level by supplying sufficient money to match the demand. Alternatively it could fix the money supply at a convinced rate and let the market clear the interest rates at the balance. Trying to fix the money supply is not easy so central banks regularly set the interest rate and provide the amount of money the market demands.
The central bank(RBI) may also involve the money supply through operating on the open market. This allows it to influence the money supply through the financial base. It may choose to either buy or sell securities in the marketplace which will either inject or remove money respectively. Thus the monetary base will be affected causing the money supply to modify.