MBA in 2 minutes | Lesson 20: How Central Banks Control Money
Updated: Jan 8, 2021
We will be solving practical challenges through MBA concepts. No theory only applications !
Given the dire state of Global and Indian GDP, it has not become a luxury but rather a needed skill to be well aware of possible levers Government and Central banks have to turn the tide around. For India, the central bank reference would be RBI.
No matter what professional background you hail from or what your dream job is, its always recommended to have competitive skill advantage to not only understand but also get fundamentals right on global economics concept and applications. With that, lets get into the problem at hand.
Step 1: What is a Central Bank
In plain layman language, a central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. In modern economies, the central bank is usually responsible for the formulation of monetary policy and the regulation of member bank.
RBI's website quotes its objective as maintaining price stability and ensuring adequate flow of credit to productive sectors.
In short, Central Bank has monopoloy on supply of money !
Step 2: What role can Central Bank play in economic crisis through money control
To resolve current economic crisis like situations, Central Banks need to keep a sharp eye on how to increase economics of economies (refer lesson here) and thus usually increasing private consumption or savings lever that Central Bank aims to shoot up during bad times.
Step 3: How does Central Bank control money
Below are the 3 main tools Central Bank deploy to increase money supply in nation states to curb declining GDP problem:
Repo Rate: Repo rate is the rate at which the central bank of a country lends money to commercial banks in the event of any shortfall of funds. Lowering repo rate increases money supply to commercial banks thus allowing comercial banks to borrow more from main central bank.
Reserve Requirements: Reserve requirements are the amount of funds a bank holds in reserve to ensure it is able to meet liabilities in case of sudden withdrawals. Reserve requirements is a tool used by the central bank to increase money supply in the economy and influence interest rates. Reducing the reserve requirements regulations increases money supply for loans by banks. Compared to repo rate this tool has been relevative less used by Central banks as witnessed historically in Indian context.
Open Market Opportunities: Selling/Buying of Government bonds for money from commercial banks which affects money base directly. For eg- purchase of government bonds by central bank from commercial banks pumps money supply to commercials banks for further loans.
However, as Central Banks deploy above measures to increase GDP, we run the risk of inflation in long term, not a very favourable tool for either politicians because of negative consumer sentiment with rising prices or Central Bank (recall objectives written above). And thus economics after a point is an art because you are always at a trade off :)
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