ECONOMICS MODULE 3 PPT

BY: SEERAT, SHRUTI, TAVISHA

AND KARTIK
BCOM LLB (H), SEMESTER-3
 CENTRAL BANK: DEFINITION,
OBJECTIVES AND FUNCTIONS

• DEFINITION:
The central bank is an autonomous, powerful, government-controlled
bank tasked with regulating the banking industry, addressing currency
concerns, and advising the government on economic policy. Its primary
aim is to stabilize the currency and economy while limiting inflation.
• The central bank is an autonomous and apolitical financial institution
responsible for maintaining a nation’s economic and financial
activities.
• Each nation has its central bank, considered an apex institution that
governs its economic and banking issues and is independent in its
economic decision-making.
• Their primary responsibilities include management of currency
reserves, supervision of the banking sector, payment system
management, issuance of new currencies, advising the government
on economic issues, setting base rates, managing the money supply,
monitoring reserves, and managing foreign currency balances.
 FUNCTIONS:

• In general, any nation’s central bank’s essential tasks include determining the base rate,
regulating the money supply through open market operations, maintaining the appropriate
reserves, and managing the country’s foreign currency reserves. For better understanding, these
functions have been discussed in detail:
• 1. Base Rate Setting
Base rate setting is the most significant function of the central bank. The base rate sets the rate at
which it lends to commercial banks. Commercial banks select the interest rate on credit for the
public based on the base rate.
If the central bank raises the base rate for banks, consumers and companies would ultimately face
higher interest rates, making commercial loans more expensive. As a result, the market’s money
circulation reduces. Consequently, a decrease in the base rate results in cheaper loans.
• 2. Money Supply Control
Central banks conduct open market operations to acquire bad assets by generating liquidity for
these assets. After obtaining the funds, the company purchases financial securities or investments.
Therefore, the funds get transferred to the buyer’s banking institution. Consequently, it can pump
new funds into the economy.
CONTUNUED…

• 3. Maintaining The Required Level Of Reserves

They regulate commercial banks’ statutory cash
reserve requirements to increase or decrease the market’s money
supply.
• 4. Maintaining Foreign Exchange Reserves
They ensures sufficient foreign currency reserves to preserve the
value of a nation’s currency. It may begin to purchase the local
currency if it loses value; it signals to the market that the local
currency is in demand, causing its value to rise.
 • The main objective of a central bank is
to ensure financial stability. Depending on
the country, central banks might have other
objectives such as controlling inflation,
unemployment, interest rates, or exchange
rates. However, all these objectives are in line
with the main objective of ensuring financial
stability.
These banks perform the following operations:
• Maintaining monetary policy by regulating the
money supply and interest rates
OBJECTIVES: • Providing financial stability to the government
and commercial institutions
• Safeguarding and managing the nation’s gold,
foreign currency, and government bonds
• Overseeing the functioning of the banking
sector and balancing the nation’s banking
system
• Handling financial transactions; locally via
clearing houses and globally via networks
such as SWIFT
• Issuing new currency and coins inside a nation
• Providing financial advice to the government
 • DEFINITION:
Commercial Banks are profit-seeking financial
institutions. They receive deposits from customers at
a lower rate of interest and offer business loans at a
higher interest rate. They serve individuals, small-
scale businesses, and medium-sized businesses.
• Commercial banks are licensed financial
C O M ME R C IA L BA N K: institutions that provide banking solutions to their
D E F IN IT IO N , O B J E C T I V E S clients—individuals, small businesses, and
AN D FU N C T I O N S medium-sized firms.
• Commercial finance institutions serve both
individuals and businesses. Retail banks on the
other hand extend services only to individuals.
• These institutions also execute various secondary
functions for their client—overdraft facility, agency
services, discounting bills of exchange, traveler’s
check, investments, and locker facility.
 FUNCTIONS:

The functions of commercial banks are classified into two main

divisions.

(a) Primary functions

• Accepts deposit : The bank takes deposits in the form of saving,
current, and fixed deposits. The surplus balances collected from
the firm and individuals are lent to the temporary requirements of
the commercial transactions.
• Provides loan and advances : Another critical function of this
bank is to offer loans and advances to the
entrepreneurs and business people, and collect interest. For every
bank, it is the primary source of making profits. In this process, a
bank retains a small number of deposits as a reserve and offers
(lends) the remaining amount to the borrowers in demand loans,
overdraft, cash credit, short-run loans, and more such banks.
• Credit cash: When a customer is provided with credit or loan,
they are not provided with liquid cash. First, a bank account is
opened for the customer and then the money is transferred to the
account. This process allows the bank to create money.
 • Discounting bills of exchange: It is a written
agreement acknowledging the amount of money to
be paid against the goods purchased at a given point
of time in the future. The amount can also be cleared
before the quoted time through a discounting method
of a commercial bank.
• Overdraft facility: It is an advance given to a
customer by keeping the current account to overdraw
up to the given limit.
(B) SEC O N D A RY
• Purchasing and selling of the securities: The
F U N C T IO N S bank offers you with the facility of selling and buying
the securities.
• Locker facilities: A bank provides locker facilities to
the customers to keep their valuables or documents
safely. The banks charge a minimum of an annual fee
for this service.
• Paying and gathering the credit : It uses different
instruments like a promissory note, cheques, and
bill of exchange.
 • The primary objective of commercial banks
is Profit Maximization which is attained by
offering a wide variety of services to
individual and business customers.
The banking industry as a whole runs the
economyof a nation. The roles of a
commercial bank are as follows:
• They aid in the successful implementation
of monetary policies.
OBJECTIVES: • They boost the industrial sector by offering
short, medium, and long-term finance.
• They accelerate trade by offering agency
services, overdraft facilities, and other
solutions to wholesale and retail businesses.
• These financial institutions help lower
and middle-class customers in procuring
consumer products on loans—easy
repayment options.
• Banks also operate on rural and regional
fronts.
 The agricultural sector receives
strong financial backing from
commercial institutions
facilitating crop cultivation,
irrigation facilities, dairy farming,
poultry farming, horticulture, and
pisciculture.

They adopt innovative ways to

facilitate easy banking—
automation, digitalization, and
CONTINUED… artificial intelligence.

They ensure a superior level of

data security for their clients.
 METHODS OF CREDIT CONTROL

Credit control can be defined as a process of monitoring and managing

credit offered to customers to minimize the risk of bad debt, late
payments, and cash flow problems. its purpose is to ensure effective
credit management as it is essential for any business to ensure a
smooth flow of cash and maintain financial stability.
Credit control is used by a team who assigns a credit limit to the
customer, which reflects their risk profile and ability to pay. This
helps to manage credit risk and prevent potential bad debt. It is
essential for managing credit risk and ensuring timely customer
payment. By implementing a credit control policy, companies can
reduce their exposure to bad debt and improve their financial health.
• Methods of Credit Control

Different methods are used by the Central Bank to control

credit, which is broadly classified into two main categories:
 Q UA NTITATIV E METHODS OR
GENERA L METHODS

• Quantitative Methods of Credit Control are related to Quantity or Volume of Money

and are aimed at regulating the total volume of bank credit. These tools are indirect
in nature and they tend to influence the loanable funds of the commercial banks.
• The total quantity of deposits created by the commercial banks is expected to be
controlled and adjusted using these methods. It maintains a balance between
savings and investment.
• 1. Bank Rate Policy: Otherwise called a discount rate policy. It is described as
the standard rate at which the central bank is ready to purchase and rediscount
eligible instruments like government-approved bills and commercial papers. It has a
great influence on the availability and cost of credit.
When the central bank increases the bank rate, it may result in a reduction in the
volume of borrowings by the commercial bank from RBI, whereas when the RBI
reduces the bank rate, the borrowings become economical for the commercial bank
and thus encourages credit expansion of the economy.

• 2. Open Market Operations (OMO): It implies trading of eligible securities

by the country’s apex bank, i.e. RBI in both capital market and money market. When
the central bank purchases or sells short term or long term securities, it leads to an
increase or decrease in the financial resources of the commercial bank.
• 3. Variations in the Reserve Ratio: We all know that commercial banks have to
maintain a specified percentage of their net demand and time liabilities as Cash
Reserves, with RBI. As well as a certain proportion of their net demand and time
liabilities has to be maintained by the banks in the form of liquid assets. These
reserve ratios are called Cash Reserve Ratio (CRR) and
Statutory Liquidity Ratio (SLR)respectiveEven the slightest change in these ratios
can affect the reserve position of the commercial banks, which in turn regulates the
supply of money in the economy.

• 4. Repo, i.e. Repurchase Option: Repo or otherwise called Repurchase

transactions are carried out by the central bank, to regulate the money market
situation. As per this transaction, the Central bank grants loan to commercial banks
against government-approved securities for a fixed period, at a specified rate,
called as Repo Rate, on a condition that the borrower bank will repurchase the
securities at the predetermined rate, once the period is over.
QUALITATIVE METHODS OR SELECTIVE
METHODS

• Qualitative Methods are used in

addition to general credit control
methods. there are a number of
situations wherein quantitative methods
may not work effectively and may
cause harm to particular sectors. As the
quantitative methods of credit control,
control the volume of credit, as a whole.
So, there are chances that it may affect
genuine productive purposes.
• In this way, the qualitative methods of
credit control come into the picture,
wherein the credit is made available to
productive and priority sectors, while
the others are restricted.
• 1. Fixation of margin requirements: In this technique, the central bank determines the margin
which commercial banks and financial institutions need to maintain for the amount extended by them
in the form of loans, against commodities, stocks and shares. The central bank also prescribes margin
requirements for the underlying securities, so as to restrict speculative dealing in stock exchanges.

• 2. Credit Rationing: As per this method, the central bank attempts to restrict the upper ceiling of
loans and advances to a particular sector. Moreover, in specific cases, the central bank may also fix
the ceiling for different categories of loans and advances. Also, commercial banks are expected to
stick to this limit. This facilitates the lessingt of bank credit exposure to unwanted sectors.

• 3. Regulation of Consumer Credit: With an aim of regulating consumer credit, the apex bank
determines the down payments and the length of the period over which installments are to be spread.
At the time of inflation, higher restrictions are levied to control the prices by controlling demands
whereas, at the time of depression, relaxations are provided so as to increase demand for goods.

• 4. Control through directives: In this technique, the central bank issues directives from time to
time so as to regulate the credit created by the commercial banks. These can be written orders,
warnings, notices, or appeals.
• It can help in regulating lending policies of the commercial banks or to fix a maximum limit of credit
for specific purposes and also to restrain the flow of bank credit into non-essential lines. It may result
in diverting the credit to productive use.
• . 5.Moral Suasion: As per this method, the Reserve Bank of India exercises a moral
influence on the commercial banks, in the form of advice, suggestion, guidelines,
directives, request, and persuasion.
This is to ensure cooperation from the central bank. However, if the commercial bank does
not comply with the advice extended by RBI, then they are not subject to any penal
action. The success of this method mainly relies on the cooperation between the two
banks i.e. central and commercial. It is helpful in limiting credit at the time of inflation in
the economy.

• 6. Publicity: As per this method, the central bank publishes numerous reports in the
form of bulletins, to state the good and the bad in the system, as well as to educate
people about its view regarding credit expansion and contraction. This can help in
informing the commercial bank to direct the supply of credit in the desired sectors.
In this way, the commercial banks get guidance from the Central bank and can modify
their lending policies accordingly.

• 7. Direct Action: This technique is used by the central bank to enforce both
quantitative and qualitative methods, and used as an adjunct to other methods. Further,
the apex bank is authorized to take action against those banks which do not comply with
the instructions extended or directives as well as it may refuse to rediscount their bills of
exchange and commercial papers.
 WHAT IS CREDIT
CREATION?

• Credit creation refers to expanding the

availability of money through the
advancement of loans and credit by banks
and financial institutions. These institutions
use their demand deposits to provide loans to
their customers, giving borrowers higher
purchasing power and competitive interest
rates.
• In the process of credit creation, banks keep
some share of their deposits as minimum
reserves to meet the demand of their
depositors. Thus, banks lend out the
excess reserves for loans and investment
purposes, and the interest earned becomes
income for the banks. Therefore, the factors
 BASIC OF CREDIT CRATION

The basis of credit money is the (1) Primary deposits, and (2) Derivative deposits.
bank deposits.
The bank deposits are of two
kinds viz.,
 PRIMARY
DEPOSITS

• Primary deposits arise or formed

when cash or cheque is
deposited by customers.
• When a person deposits money
or cheque, the bank will credit
his account.
• The customer is free to withdraw
the amount whenever he wants
by cheques.
• These deposits are called
"primary deposits" or
"cash deposits."
DERIVATI • Bank deposits also arise
when a loan is granted or
when a b a n k discounts a
••

VE bill or purchase government

securities.
DEPOSITS • • Deposits which arise on
account of granting loan or
purchase of assets b y a bank
a r e called "derivative
deposits."
• • Since the bank play an
active role in the creation de
sust deposits, they are also
known as "active
• • Thus, credit creation
implies multiplication of bank
depos
 PROCESS OF CREDIT CREATION

• An important aspect of the credit creating function of

the commercial banks is the process of multiple-
expansion of credit.
• The banking system as a whole can create credit
which is several times more than the original increase
in the deposits of a bank.
• This process is called the multiple-expansion or
multiple-creation of credit.
• Similarly, if there is withdrawal from any one bank, it
leads to the process of multiple-contraction of credit.
 CONT...

• • The process of multiple credit-

expansion can be illustrated by
assuming:
• a)
• The existence of a number of banks,
SBI, BARODA, AXIS etc., each with
different sets of depositors.
1.Every bank has to keep 20% of cash
reserves, according to law, and,
2.A new deposit of Rs. 1,000 has been
made with
SBI to start with.
 • • Suppose, a person deposits Rs. 1,000 cash in
SBI BANK. As a result, the deposits of SBI BANK
increase by Rs. 1,000 and cash also increases
by Rs. 1,000.
• Suppose X purchase goods of the value of Rs.
800 from Y and pay cash. Y deposits the
amount with BARODA BANK. The deposits of
HOW CREADIT BARODA BANK now increase by Rs. 800 and its
CRATION BY BANK cash also increases by Rs. 800. After keeping a
cash reserve of Rs. 160, BARODA BANK is free
to lend the balance of Rs. 640 to any one.
Suppose BARODA BANK lends Rs. 640 to Z,
who uses the amount to pay off his creditors.
 .

• In the above example, there will be 10 fold increase in

credit because the cash ratio is 10%.
The total volume of credit created in the banking
system depends on the cash ratio. If the cash ratio is
10% there will be 10 fold increase. If it 1s 20%, there
will be 5 fold increase
• The extent to which the banks can create credit
together could be found out with the help of the credit
multiplier formula. The formula is:
• K=1/r