(a) State any two components of M1 measure of the money supply.

(b) Elaborate any two instruments of Credit Control, as exercised by the Reserve Bank of India.

OR

Define Credit Multiplier. What role does it play in determining the credit creation power of the banking system? Use a numerical illustration to explain.

a) M1 consists of currency, demand deposits, and other deposits.

Currency includes coins and notes. It is also called fiat money. Fiat money is the money which is accepted as money under the terms of the law. It includes only the money held outside the bank, i.e., with the public and not the one which is held in the bank.

A demand deposit is a deposit held in a bank which can be withdrawn on demand by the user on demand. It is also called chequable deposits.

b) The two instruments of Credit Control, as exercised by the Reserve Bank of India are:

I- Bank rate - Bank rate is the rate at which the central bank lends money to the commercial banks as the lender of the last resort. The Reserve Bank of India controls credit by changing in the bank rate. An increase in bank rate raises the cost of credit, and credit becomes expensive. This reduces the demand for credit. A decrease in bank rate reduces the cost of credit and credit becomes cheap. This increases the demand for credit.

ii-Cash Reserve Ratio - CRR is the minimum deposit of cash held by the commercial banks with the central bank. The RBI fixes the CRR and often fluctuates it according to tot he needs of the economy. An increase in the CRR reduces the amount of excess cash held by the bank, which in turn reduces the availability of credit giving to the public. Similarly, a decrease in CRR increases the amount of excess cash held by the bank, which increases the credit-extending capacity to the public.

OR

The primary cash deposit in the bank, which leads to multiple expansion in the total deposit is called credit multiplier.

If the credit multiplier is high, more money will be created.

This can be illustrated with the following example-

Suppose that the initial deposit in a bank is Rs 1,000. The bank will use this money to extend loans to the people. But the entire money cannot be used for this purpose. The banks have to keep a specific amount of money as the cash reserve ratio. This ratio is decided by the central bank of the country. Let us assume this CRR is 10%.

Now the banks are required to keep only 10% of 1,000, which is Rs 100. The banks can lend the remaining 900 to the people. Thus the Bank has created Rs 900 + Rs 1000 = Rs 1900 of money with the initial deposit of 1000.

It is assumed that those who borrow deposit the money, in the bank again. Now the deposit is Rs 900 and considering the CRR; the banks can lend out Rs 810 rupees as loans.

Again sayings the borrower will deposit the money in the bank, the banks can lend out further. A fresh amount Rs 729 will be extended as a loan using the same above formula.

So the bank has created a total of 1900 + 810 = 2710, from the initial credit of rupees 1000.

This can also be explained by the following formula-

Money multiplier = 1/LRR

Money multiplier = 1/10%

= 1 / 0.1

= 10

The total money created would be

Initial deposit X 1/LRR

1000 X 10 = Rs10000