These are the various methods adopted by the central bank to control credit (money supply).
Credit control is the government policy/ measures through the central bank to regulate lending by commercial banks in order to influence the level of economic activities/ in order to achieve desired macro-economic activities such as price stability, full employment and B.O.P equilibrium.
During inflation, the central bank adopts measures to reduce money in circulation. Such measures constitute what we call restrictive/ contractionary/ tight monetary policy.
During a deflation; the central bank adopts measures that increase money in circulation. Such measures constitute what we call expansionary monetary policy.
These tools include:
- The Bank rate
This is the rate at which the central bank advances loans to commercial banks. During inflation, the central bank raises the bank rate which forces commercial banks to increase the interest rate as well on loans to their customers. This discourages borrowing hence the supply of money falls. In case of a deflation, the central bank lowers the bank rate which influences commercial banks to reduce interest rates to their customers thereby encouraging borrowing and hence increase in money supply.
- Open market operation (O.M.O)
This is the sale or purchase of government securities by the central bank to and from the public through an open market. During inflation, the central bank sells securities to the public and individuals who buy the securities write out cheques through their commercial banks paying the central bank. This reduces the money available to commercial banks and finally their lending capacity is reduced. In case of a deflation, the central bank buys the securities from the public hence injecting more money in circulation.
- Legal reserve requirement.
This is the proportion of customers’ deposits that by law commercial banks are supposed to deposit with the central bank. During inflation, the legal reserve requirement is increased which reduces loanable funds available with commercial banks as well as money supply. In times of a deflation, the legal reserve requirement is reduced enabling commercial banks to give more loans to the public hence increasing money supply.
- Special deposits (supplementary reserve deposits)
This is the additional deposit which commercial banks are required to keep with the central bank over and above the legal reserve requirement. Special deposits are increased during high inflation rates to discourage borrowing and reduced during times of a deflation/ recession to encourage lending by commercial banks.
- Selective credit control
This tool is commonly used during times of high inflationary rates. The tool involves the central bank directing commercial banks to advance loans to a few priority sectors of the economy like agriculture and industry and deny the other sectors. This reduces the number of sectors getting loans hence reducing money supply. During a deflation, the selective credit control tool is abolished.
- Margin requirement
This is the difference between the value of the collateral security required to acquire a loan and the actual amount of the loan advanced. During inflation, the central bank raises the margin requirement which makes borrowing expensive hence a decrease in money supply. During a deflation, the central bank lowers the margin requirement and borrowing becomes cheap hence increasing money supply in the economy.
- Moral suasion
This involves the central bank appealing to/ requesting/ persuading commercial banks to behave in a specific way when extending credit for purposes of regulating money supply. The central bank does this by writing letters or circulars to commercial banks. The commercial banks do what they are told because they depend on the good will of the central bank for their operations.
- Direct action (direct government intervention)
The central bank at times issues orders to commercial banks to advance more or less loans as may be required to control money supply. The central bank does not give any financial accommodation to all banks that may fail to comply. Actions taken may include;
- Refusal to grant loans
- Monetary penalties.
- Changing the terms and conditions of rediscounting.
- Refusal to grant rediscount facilities among others.
- Cash ratio
This is the percentage of commercial bank deposit that must be kept in cash form to meet the cash demands of the depositors. The percentage is increased during periods of high inflation rates to reduce the money available for lending and reduce money supply and reduced when the central bank wants to increase the amount of loanable funds and money supply.
- Rationing of credit
This involves the central bank prescribing the maximum amount in terms of loans that commercial banks should give in a period of time or how much commercial banks can get from the central bank in terms of advances. During inflation, the central bank limits the amount of loans advanced to commercial banks i.e. they can only borrow up to a certain limit hence reducing money supply. During a deflation, the maximum is raised or waived off altogether.
- Currency reforms
The central bank through the banking institutions and other financial intermediaries withdraws the existing legal tender from circulation and issues new currency after reducing the value of the one in circulation by a given proportion. For example the government of Uganda made a currency reform and introduced new currency in 1987.