There are different policy instruments through which the monetary authority regulates the money supply, thereby, helpful in reducing excess demand in the economy. The following are the various monetary policy instruments that the Central Bank uses to combat the excess demand.
(i) Bank Rate: Bank rate refers to the rate at which the Central Bank provides loans to the commercial banks. This instrument is a key at the hands of RBI to control the money supply. Changes in the bank rate change the cost of borrowings, thereby affect the money supply and aggregate demand. In case of excess demand, Central Bank raises the bank rate, thereby increases the cost of borrowings for the Commercial Banks. This discourages the demand for loans and credits in the market. Therefore, the consumption expenditure falls and hence, aggregate demand falls.
(ii) Open Market Operations (OMOs): Open Market Operations refer to the buying and selling of securities either to the public or to the commercial banks in an open market. These operations are carried out by the Central Bank to affect the money supply in the economy. In case of excess demand, the Central Bank sells the securities, in order to restrict the supply of the money in the market. This reduces the spending capacity of the people, resulting in a lower level of aggregate demand, thereby, reduces the excess demand.
(iii) Cash Reserve Ratio (CRR): It refers to the minimum proportion of the total deposits that the Commercial Banks have to maintain with the Central Bank in form of reserves. Through CRR, the Central Bank influences the level of aggregate demand by controlling the availability of credit in the market. In case of excess demand, the Central Bank raises CRR. This implies that the Commercial Banks have to maintain a greater portion of their deposits in form of reserves with the Central Bank. This reduces the lending capacity of the Commercial Banks, consequently, lesser volume of credit and loans will be granted to the public. This further reduces the flow of money in the economy, thereby reduces the level of aggregate demand.
(iv) Statutory Liquidity Ratio ( SLR): Statutory Liquidity Ratio ( SLR) is defined as the minimum percentage of assets to be maintained by the Commercial Banks with themselves in the form of either fixed or liquid assets. Similar to the CRR, the Central Bank uses SLR to influence the aggregate demand by affecting the flow of credit. In case of excess demand, the Central Bank raises SLR. This restricts the Commercial Banks to pump additional money into the economy. As a result, money supply is reduced, resulting in lowering of the aggregate demand.
