Methods of credit control and the objectives of monetary policy

1. Meaning and objects of credit control

Credit control means the regulation by the central bank of the volume, cost and direction of bank credit. Bank credit is the largest part of the money supply, so controlling it is the main way of controlling money. The objects are: stability of prices, stability of the exchange rate, control of the trade cycle (curbing credit in a boom, expanding it in a slump), promotion of growth and employment, and directing credit to priority uses and away from speculation.

2. Quantitative (general) methods

These affect the total volume of credit, whatever its use.

(a) Bank rate policy

The bank rate is the standard rate at which the central bank rediscounts eligible bills or lends to commercial banks (section 49, RBI Act). To check inflation it raises the bank rate: borrowing from the central bank costs more, banks raise their own lending rates, borrowing and spending fall, and prices fall. A cut in the bank rate works the other way. It was the main tool of the Bank of England under the gold standard.

Limitations: banks may not need to borrow from the central bank if they have surplus funds; the unorganised money market is outside its reach; in a boom high profit expectations outweigh a higher interest cost, and in a depression low rates do not induce borrowing (“you can lead a horse to water but cannot make it drink”). In India the bank rate now moves with the marginal standing facility rate and the repo rate is the operative signal.

(b) Open market operations (OMO)

The purchase and sale of government securities by the central bank in the open market (section 17(8), RBI Act). To contract credit it sells securities: buyers pay by cheques on their banks, bank reserves with the central bank fall, and banks must reduce lending by a multiple of the fall. To expand credit it buys securities, adding to bank reserves. OMOs are flexible, can be used in small doses and are reversible.

Limitations: they need a broad and active securities market; banks may hold excess reserves that offset the effect; and the public’s demand for loans must respond. In India OMOs are also used to manage liquidity and the government borrowing programme, and the Market Stabilisation Scheme (2004) was introduced to absorb liquidity from capital inflows.

(c) Variable reserve ratios

• Cash reserve ratio (CRR): the percentage of net demand and time liabilities a bank must keep as cash balance with the RBI (section 42, RBI Act). A rise in the CRR reduces the credit multiplier (1/r) and lendable funds directly.
• Statutory liquidity ratio (SLR): the percentage of liabilities a bank must keep in cash, gold or approved securities (section 24, Banking Regulation Act). A higher SLR diverts funds from loans to government securities.

Reserve ratios act quickly and on all banks, but they are blunt: a small change has a large effect and hits all banks alike, whatever their position.

(d) Repo, reverse repo and the liquidity adjustment facility

Under the Liquidity Adjustment Facility (2000), the RBI lends to banks overnight against government securities at the repo rate, which is its policy rate, and absorbs surplus funds. Since April 2022 the floor of the interest-rate corridor is the Standing Deposit Facility (absorption without collateral) and the ceiling is the Marginal Standing Facility (emergency borrowing at a penalty rate). A rise in the repo rate raises the cost of funds and, through banks’ external-benchmark lending rates, the cost of loans to borrowers.

3. Qualitative (selective) methods

These regulate the direction and use of credit, not its total volume. The RBI’s power comes from sections 21 and 35A of the Banking Regulation Act.

1. Margin requirements: the margin is the part of the value of the security a borrower must provide himself. Raising margins on loans against, say, foodgrains or shares curbs speculation and hoarding in those goods.
2. Credit ceilings and rationing: limits on total credit or on credit to particular sectors; quotas for rediscounting.
3. Regulation of consumer credit: minimum down payments and maximum repayment periods for hire-purchase and instalment buying.
4. Discriminatory interest rates: lower rates for priority sectors, higher for non-essential uses.
5. Moral suasion: persuasion, letters and meetings urging banks to follow policy, without legal compulsion.
6. Direct action: penalties, refusal of rediscount facilities, or other action against banks that disregard directions.
7. Publicity: publication of data and policy reasons to build public support.

Limitations: credit is fungible (a loan for one purpose can be diverted to another); non-bank lenders are outside control; administration is difficult. But selective controls can fight inflation in particular goods without starving the whole economy of credit, which suits a developing country.

4. Monetary policy: meaning and objectives

Monetary policy is the policy of the central bank on the supply of money, the cost of money (interest rates) and the availability of credit, used to achieve the economic goals of the State. Its objectives:

1. Price stability: the principal objective. India adopted flexible inflation targeting in 2016; under section 45ZA of the RBI Act the target is 4 per cent CPI inflation within a band of 2 to 6 per cent.
2. Economic growth: adequate and cheap credit for investment.
3. Full employment (Keynesian goal), by maintaining aggregate demand.
4. Exchange rate stability, to protect trade and confidence in the currency.
5. Equilibrium in the balance of payments.
6. Neutrality of money (Wicksell, Hayek): money should not itself disturb the real economy; an older view.
7. Equitable distribution and credit to weaker sections and priority sectors.
8. Financial stability: a sound banking system and orderly markets.

Conflicts. Objectives clash: price stability against growth and employment (the Phillips curve trade-off); exchange rate stability against domestic price stability; growth against the balance of payments. Hence the modern practice of giving one primary objective (inflation) with growth as a secondary aim.

Monetary Policy Committee. Since 2016 the policy repo rate is decided by a six-member Monetary Policy Committee (section 45ZB, RBI Act): the Governor (who has a casting vote), a Deputy Governor, one RBI officer and three external members appointed by the Central Government.

5. Monetary and fiscal policy

Fiscal policy is the government’s policy on taxation, public expenditure and public borrowing. It acts on demand directly through the Budget, while monetary policy acts indirectly through money and interest rates. Fiscal policy is set by the government and Parliament; monetary policy by the central bank. The two must be coordinated: large fiscal deficits financed by money creation defeat monetary control of inflation.

How this is examined

For the 10- or 16-mark question on credit control, write the quantitative methods with the mechanism of each (raise rate, then cost of credit, then demand, then prices) and the qualitative methods as a list with one line each, and close with the limitations. For six-mark notes, use sections 2(a), 2(b) or 2(c) alone, or the list of objectives with a line on conflicts and the MPC. “Fiscal policy” (January 2025) is outside the syllabus list; section 5 is enough.