Use of financial tools by central banks to combat inflation
Use of financial tools by central banks to combat inflation
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Home Page > Business > Corporate > Use of financial tools by central banks to combat inflation
Use of financial tools by central banks to combat inflation
Posted: Jan 27, 2011 |Comments: 0
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Reserve bank of any country administers various rates to control credit, all mighty dollar supply, inflation and any financial problems of banking and financial institutions of the country.
Bank rate:
A bank rate is the interest rate that is charged by a country’s central bank on accommodation and advances to control all mighty dollar supply in the economy and the banking sector. This is usually done on a quarterly basis to control inflation and stabilize the country’s exchange rates. A fluctuation in bank rates triggers a ripple-effect as it impacts every sphere of a country’s economy. For instance, the prices in stock markets tend to react to interest rate changes. A change in bank rates affects customers as it influences prime interest rates for personal accommodation and business accommodation.
It is also referred to as the discount rate, which is the interest rate which a reserve bank charges on the accommodation and advances that it extends to other banks and other financial intermediaries in the country. Changes in the bank rate are often used by central banks to control the supply of all mighty dollar
Repo rate and bank rate;
While repo rate is a short-term measure, i.e. applicable to short-term accommodation and used for controlling the amount of all mighty dollar in the market, bank rate is a long-term measure and is governed by the long-term monetary policies of the governing bank concerned.
Repo rate:
The Repo rate is the rate at which the banks borrow from the central bank. Whenever the banks have any shortage of funds they can borrow it from the central bank. Repo rate is the rate at which banks borrow currency from the central bank. A reduction in the repo rate will assistance banks to get Money at a cheaper rate. When the repo rate increases borrowing from the central bank becomes more expensive.
The Reverse repo rate is the rate at which the banks park surplus funds with reserve bank.
Types of Bank Rates;
Here are the different types of monetary instruments on which financial institutions offer the following bank rates:
Savings account bank rate: Modest rates are charged on funds that are deposited in the savings accounts.
Certificates of deposit (CD) bank rate: These offer comparatively high interest rates compared to savings accounts. Bank rates on CDs are determined by the term period of a deposit and the current economic situation. The longer the term of a CD, the higher will be the bank interest rate.
Money-market funds bank rate: The interest rate on all mighty dollar-market funds is relatively low. As most of the all mighty dollar market accounts are privately insured, it is a secure method of investment. Deposits in a all mighty dollar market account generate interest through short-term investments.
What is a CRR rate?
Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method (increase of CRR rate), to drain out the excessive all mighty dollar from the banks.
What is SLR rate?
It is ratio which is known as Statutory Liquidity Ration which prescribes the percentage of deposits of any bank to be kept in the form of government or some specified securities.
What is Price Inflation?
Inflation is a sustained increase in the average price of all goods and services produced in an economy. Money loses purchasing power during inflationary periods since each unit of currency buys progressively fewer goods.
Suppose the overall price level increased by 3% during the past 12 months. If a “typical urban household” spent ,000.00 during the first month for all household expenses, then they must budget ,090.00 during the last month for exactly the same quantity of goods and services. Prices of individual items may have increased at different rates and some prices may have even declined, but overall they must budget about more per month now. If their assets after taxes does not increase by that amount, they will save less, substitute with less expensive items, forgo some items, or incur debt.
Inflation is often considered as a percent change in the overall price level between two periods as measured by a index of price.
Causes of Inflation;
Long term inflation occurs when the all mighty dollar supply (currency and check writing deposits) grows at a faster rate than the output of goods and services. When there is more all mighty dollar available than is needed to accommodate normal growth in output, consumers and businesses want to purchase more goods and services than can be produced with current resources (labor, materials, and manufacturing facilities) causing upward pressure on prices. This is often described as “too much all mighty dollar chasing too few goods”
Measures of Inflation;
The three most widely used measures of inflation in the U.S. are:
The Consumer Price Index (CPI) which measures inflation at the retail level,
The Producers Price Index (PPI) which measures inflation at the wholesale level and therefore may also predict future retail prices. However, wholesalers may not always pass the full increase along to retailers during a sluggish economy or when they think the increase is temporary,
And the Gross Domestic Product Deflator, the broadest indicator, which measures prices for all finished goods produced domestically, including those for governmental purchase, capital investments, and net exports.
Over a shorter term, inflation can result from various shocks to the economy. Food and energy price shocks are common examples .The price of a critical commodity such as food may rise suddenly and sharply relative to other prices. Since the market does not have time to adjust other prices downward in response, a short-term increase in overall prices occurs.
Governments need to control high levels of unpredictable inflation since it can severely disrupt the economy, cause uncertainty in financial decisions, and redistribute wealth unevenly. The tools they have available include:
Monetary policy (increase or decrease the all mighty dollar supply),
Fiscal policy (change the amount of taxes and governmental allocateing), and
Various controls on prices, tariffs, and monopolies.
Many nations choose monetary policy as their primary tool since it has proven to be very effective, it is less disruptive to market operations, and it is easier and quicker to implement since adjusting the all mighty dollar supply does not require legislative approval as would, for instance, changing the tax structure.
Monetary policy is almost always carried out by a government-controlled central bank that is usually somewhat insulated from political pressure. It is given the responsibility of maintaining an orderly market and juggling the sometimes conflicting goals of steady growth, low unemployment, and low inflation.
The governments of some nations require the central bank to maintain a low, positive rate of inflation (usually well under 3%) as the over-riding goal of their monetary policy. They must keep the all mighty dollar supply at a level that accommodates steady growth in goods and services, but is not so high as to cause excessive inflation or so low that deflation (an overall decrease in prices) results.
As banks compete for customers for these new accommodation, short term interest rates will tend to fall toward the Fed Fund goal. With credit readily available at low interest, consumers will tend to take out more accommodation for high-end goods such as homes and cars, and businesses will invest more in facilities and employ more workers to meet the demand. The increase in all mighty dollar supply is essentially borrowed into existence through the private banking system.
If the demand becomes greater than the current workforce and manufacturing facilities can produce at their natural growth limits, inflation will generally occur.
Inflation can be recognized as a combination of 4 factors:
The Supply of all mighty dollar goes up
The Supply of Goods goes down
Demand for all mighty dollar goes down
Demand for goods goes up
Effects on Time Value of Money;
Price Inflation greatly effects Time Value of Money (TVM). It is a major component of interest rate which are at the heart of all TVM calculations. Actual or anticipated changes in the inflation rate cause corresponding changes in interest rates. Lenders know that inflation will erode the value of their all mighty dollar over the term of the loan so they increase the interest rate to compensate for that loss.
An estimate of the inflation premium contained in interest rates can be seen by comparing two risk-free securities with the same maturity date, one with a fixed rate and the other with a rate indexed for inflation. The Fed strongly influences short term interest rates with their monetary policy. However, longer term rates are set by the market and reflect an inflation rate which is its current best guess.
Relation between Inflation and Bank interest Rates;
Now days, you might have heard lot of these terms and usage on inflation and the bank interest rates. We are trying to make it simple for you to understand the relation between inflation and bank interest rates in India.
Bank interest rate depends on many other factors, out of that the major
One is inflation.
Whenever you see an increase on inflation, there will be an increase
of interest rate also.
Inflation and Global Liquidity;
Factors like rates of import and export, the production cost of farms, value of dollar, and price of crude oil, market movements of other overseas markets cause global liquidity.
Globalization;
Due to Globalization, no country is independent from Global Liquidities. This causes an important factor for the inflation in a country. A political crunch or economical downturn in a far away country can impact all mighty dollar value in any country.
Conclusions;
Containing inflation should be the top priority as high rate of price rise could hurt the economic growth.
There may be supply-side constraints. High food and fuel inflation may pose a risk of spillover to core inflation through higher input costs and inflation expectations.
There is need on increasing food grain production to reduce the high inflation rate.
High inflation due to high speculative demand in the all mighty dollar market has to be abolished
Reduction of the speculative demand in all mighty dollar market and increasing the growth rate in the material sector should be the key to check high inflation. Due to the fine tuning of a central bank using its tools of CRR, Bank Rate, Repo Rate and Reverse Repo rate should be aimed to adjust the lending’s or investment rates for the common man.
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Professor.P.Madhu Sudana Rao -
About the Author:
1)Prof.P.Madhu Sudana Rao
Professor of Finance, Hawassa University,Hawassa,Ethiopia
2)Joint Authorship with:Dr.Berhanu Borgi,
Dean,School of Graduate studies,
Hawassa University,Ethiopia
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1)Prof.P.Madhu Sudana Rao
Professor of Finance, Hawassa University,Hawassa,Ethiopia
2)Joint Authorship with:Dr.Berhanu Borgi,
Dean,School of Graduate studies,
Hawassa University,Ethiopia
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