This Blog talks about the role played by Central bank of a Country:
Central bank controls monetary policy of the country. It has power to control money supply in the economy which in turn impacts inflation, employment, interest rates etc. Money circulation in short is ; what amount of currency should be in market. RBI/Fed controls these by impacting some key ratios
These important ratios are mentioned below:
Repo Rate: Whenever the banks have shortage of funds they can borrow from Central Bank(RBI, Federal Reserve). Repo rate is the rate at which banks borrow money from Central Bank. So clearly, a reduction in repo rate means that banks can borrow money at lower rate.
Repo rate is short term for repurchase rate. Repo rate is the discounted rate at which RBI/Fed buys back(repurchases) the government securities from banks to reduce some of the short term liquidity (make sure banks could honor withdrawals of customers) in the market. Alternatively central bank decides the desired level of money supply and lets the market decide the repo rate. Securities are sold at original market price and interest and a pre-agreed interest rate, called as Repo rate.
Reverse Repo Rate: Reverse repo rate is the rate at which Central bank borrows money from (national) banks. Banks always prefer to lend money to central bank because they get a good interest rate and definitely their money is in safe hands. So an increase in Reverse Repo Rate can cause banks to transfer more money to central bank.
This rate is just opposite of repo rate. Central bank uses this tool when it feels that there is too much money floating in the market. If the reverse repo rate is increased then banks will prefer to keep their money with Central bank which is risk free instead of lending it out.
Reverse repo rate signifies the rate at which central bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is injected.
Cash Reserve Ratio/ Reserve Ratio / CRR : The required percentage of reserves that banks must hold in cash or deposit at the Federal Reserve / Central Bank. This varies from time to time and is set by the central bank.
If the federal bank fixes the CRR as 10%, this means that all the banks of the country have to keep 10% of the depositors money with them or with Central bank in the form of cash. All the banks use their depositors money in providing the credit and they try to expand their credit volume to generate higher profit. In such situation CRR compels banks to keep the fixed amount of money so that they can pay customers in the hour of their need. This ratio also helps in increasing/decreasing the money supply in the economy.
Central Bank's primary goal is to raise or lower short-term interest rates. In doing this RBI/Fed can indirectly influence demand, which then influences economy. For example, if interest rates are lowered, borrowing money to make purchases becomes less expensive, and people are more motivated to spend money because they can get a better deal on the loan. Spending money, in turn stimulates economic growth, and that's what is expected out of Central Bank. If there are too much money in the economy, however, people spend more money and demand increases at faster rate then supply can match. Price rise too quickly because of shortage of products, and inflation results. If there is too little money in the economy, people don't have excess spending money, and there is little economic growth. Central bank watches economic indicators closely to determine in which direction the economy is going. By forecasting increases in inflation or slow-downs in the economy, Fed/RBI knows whether to increase or decrease the supply of money.
