Definition: A moderate rate of inflation is considered desirable for the economy, and it varies from country to country and from time to time. As the inflation crosses the desirable rate, several measures to control inflation are undertaken. Often, the countries use monetary measures to keep the situation under control.
Monetary Measures to Control Inflation
The monetary measures which are widely used to control inflation are:
- Bank Rate Policy: The bank rate policy is used as an important instrument to control inflation. The Bank rate, also called as the Central Bank rediscount rate is the rate at which the central bank buys or redsicounts the eligible bills of exchange and other commercial papers presented by commercial banks to build their reserves. Here, the central bank performs the function as “lender of the last resort”.The bank rate policy as a monetary measure to control inflation work in two ways:
- During inflation, the central bank raises the interest rates due to which the borrowing costs go up. As a result, commercial bank borrowings from the central bank reduces. With the reduced borrowings from the central bank, the flow of money from the commercial bank to the public also gets reduced. This is how the bank credit decides the extent to which the inflation is controlled.
- The bank rate sets the trend for general market interest rate, specifically in the short-run. As the central bank raises the interest rate with a view to curtailing the money supply in the market, the commercial banks also raise their commercial borrowing rates for the public, thereby making the borrowings dear. Other general market rate follows the suit and with the decreased borrowing capacity of individual, the inflation is controlled due to reduced money flows to the society.
- Variable Reserve Ratio: The variable reserve ratio, also called as the Cash Reserve Ratio (CRR) is a certain proportion of total demand and time deposits that the commercial banks are required to maintain in the form of cash reserves with the central bank.
The cash reserve ratio is often determined and imposed by the central bank with a view to controlling the money supply. When the central bank raises the CRR, the lending capacity of the commercial banks reduces due to which the flow of money from the banks to the public also decreases. Thus, it helps in controlling the rise in the price to the extent it is caused by the bank credit to the public.
- Open Market Operations: The open market operations are characterized by the sale and purchase of government securities and bonds by the central bank. The central bank buys and sells the government securities and bonds to the public through commercial banks. The government securities are sold via commercial banks such that a certain amount of bank deposits is transferred to the central bank. As a result, the credit creation capacity of the commercial banks reduces. Thus, the flow of money from the banks to the public also gets reduced.
Thus, these are the major monetary measures that countries use to keep the inflationary pressures under control or maintain the desirable limit of inflation.