Posted in Finance Articles, Total Reads: 4842
, Published on 15 April 2011
Since medieval times, trade and business has gradually evolved and prospered. Earlier there was trade of art, tools, cattle and the most important medium was a barter system, where goods were exchanged in terms of kind. Gradually, over a few centuries gold coins, copper coins etc became the face of transactions, providing a relative value of goods and services which would use these coins for economic activities. But since the nineteenth century, almost in every country money and currency notes and coins were used as a medium of economic activity. Thus it became the responsibility of governments of every nation to control the wealth of the nation for prosperity and sustainable economic growth.
The amount of coins and notes, i.e. money in circulation alongwith the reserve ratio the banks set, determines the money supply in a country. In most countries across the world, the central bank doesn’t try to have a control over the total value of the money in circulation. The central bank will sell as many notes and coins to the other commercial banks and later, it just debits the accounts of the banks by the specific amount. This is what is followed in the British monetary system, which enables the central bank to control money not only in their branches, but in other accounts also. In India, RBI credit policies asserts a control over the banking system in India.
The Central bank, and not the commercial banks, has the responsibility to decide the reserve ratio that is to be followed. In UK, Bank of England specified the amount of notes that a bank must possess alongwith amount on deposit, plus the money generated by the bank as revenue from loans etc. Thus, if the inflation was high due to excess money in circulation, banks would be forced to reduce their lending. Now, the system has been changed slightly. After pressure from commercial banks, the central bank removed minimum reserve ratio but now works individually as per a banks requirement. However, this has reduced the Central bank's control on supply and circulation of money.
Having 'Open market operations' is another way by which money supply can be controlled. Selling or buying of interest bonds to financial organisations generate revenue through cheques drawn on accounts in their commercial banks. The Central Bank debits accounts that commercial banks operate with it by the required amounts. However, if the Central bank wants to exercise its control and wants to increase money in circulation, it can purchase bonds which they themselves or a local council had issued earlier.
Altering the interest rate at which it lends funds to banks is another way in which the Central bank can exercise control over the money supply. This is the most effective and prominent method which is followed in controlling money supply. The banking system i.e. commercial banks are deprived and kept short of money. Whenever they require money, the central bank can exercise control by defining and laying guidelines for lending interest rates. If the government is collecting less than spending, then a shortage can be created by Central bank by simply selling bonds. The Bank then lends the other banks funds they need to keep their accounts with it in credit at an interest rate that sets rates at which bank lend to each other, and their customers. This clearly defines how much customers can borrow, thereby having a control on national money supply.
Money is required for every transaction and economic activity or trade that occurs in a country. A slight fluctuation, can cause billions of dollars of loss or gain. Thus, to maintain stability in the economy, the most important activity is exercising control over a country's money in circulation.
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