Explain how the bank credit channels two channels of monetar

Explain how the bank credit channels (two channels) of monetary policy transmission operate.

Illustrate with the scenario where the Federal Reserve Bank undertakes an open market purchase.

Solution

The bank credit channels (two channels) of monetary policy:-

1) Cash reserve ratio:- It is the minimum percentage of bank\'s total deposits required to be kept with the Central bank of the country. Commercial banks have to keep with the central bank a certain percentage of their deposits in the form of cash reserves as a matter of law. When the cash flow or credit is to be increased, minimum cash reserve ratio is reduced, and when the cash flow or credit is to be reduced, minimum cash ratio is increased.

2) Statutory liquidity ratio (SLR):- Every bank is required to maintain a fixed percentage of its assets in the form of cash or other liquid assets, called SLR.

With a view to reduce the flow of credit in the market, the central bank increases this liquidity ratio. However, in case of expansion of credit, the liquidity ratio is reduced.

Impact of Federal Reserve Bank undertaking an open market purchase:-

Open market purchase refers to purchase of securities in the open market by the central bank. By buying the securities, the central bank contributes to cash balances in the economy. With the increase in cash balances, flow of credit will increase many times more in the economy.