Chapter 12
Money and the Banking System
What is Money Supply?
–

Money supply is one of the important indicator of
macroeconomic environment

–

This refers to th...
Contd..
– Money supply is basically determined by the central
bank of a country (e.g. Reserve Bank of India) and the
comme...
Factors affecting Money supply
•
•
•
•
•

Bank credit
Deficit financing
Foreign exchange reserves
Government Expenditure
F...
What cause increase in money supply?
gulated?
 RBI has the power to print notes, they can hence release
more money into t...
How Quantity of Money is Measured

• Money supply M1
– Narrowly defined
– Coins and paper money in circulation
– Traveler’...
How Quantity of Money is Measured
• M1: This is the money supply ie the currency with the
public and demand deposits with ...
How Quantity of Money is Measured
• Near moneys
– Liquid assets
– Close substitutes for money
• Asset’s liquidity
– Ease –...
The Origins of the Money Supply

• Asset - item of value
– Owned

• Liability - item of value
– Owed / Debt

• Balance she...
Balance sheet of RBI,
December 31, 2011

Assets
Financial Assets
A) Credit to Government

- credit to centre
- loans and a...
The Origins of the Money Supply

• The Monetary liabilities of the RBI are
a) Currency issued by RBI
b) Reserves held by c...
The Origins of the Money Supply
RBI Assets= RBI liabilities
= (FA)+ OA= ML+NML
= FA+OA-NML= ML
IF NNML= (NML-OA)
Then
ML= ...
The Origins of the Money Supply

• The Monetary liabilities of the RBI are
a) Currency issued by RBI
b) Reserves held by c...
The Origins of the Money Supply
•
•
•
•
•

Ms = m .H
M= money multiplier
M= broad money
M3= C+DD+TD
m= Ms/H
H= C+R
• M=C+D...
Origins of money supply
m= 1+c+t/c+ r(1+t)
m= 1+c/c+r without TD
If banks hold excess reserves
m =1+c/r+c+e
And
Ms= m H
So...
• Some body deposits $1000 in bank A.
For simplicity sake, we will show new
changes in assets and liabilities only.
• The ...
Process of Credit Creation

• A single bank cannot create loan the banking
system as a whole can make loans.
• The process...
• “This tendency on the part of the
commercial banks to make loans several
times of the excess cash reserves kept
by the b...
Do Banks Create Credit?

• Creation of credit means that the commercial
banks by taking in deposits and making loans
expan...
Bank A Balance Sheet
Assets

Liabilities

Cash received = $ 1000

Demand Deposits = $1000

We assume now that Mr. X appro...
Bank A Balance Sheet
Assets

Liabilities

Cash received = $ 200
Loan to Mr. X = 800
Total
= $1000

Demand Deposits = $1000...
Bank B Balance Sheet
Assets

Liabilities

Cash received = $ 800

Demand Deposits = $800

We further assume that Mr. N app...
Bank B Balance Sheet
Assets

Liabilities

Cash received = $ 160
Loan to Mr. N = 640
Total
= $800

Demand Deposits = $800
_...
• The amount loaned out to Mr. Z becomes a new deposits
at another bank K.
• If the process of creating secondary deposits...
• The increase is five fold, the reciprocal of
the reserve requirement which is shown
in the table below.
Example of credit creation by banking system

Banks

Primary Deposits

Cash reserve at
20%

Credit Creation

A
B
C
D
E
F
G...
•
•
•
•
•

The table shows the following points
(i) If the cash reserve ratio is 20%and
(ii) the initial deposit is $1000
...
Credit multiplier

• The credit expansion in the banking
system is influenced by the credit
multiplier.
• “The credit mult...
Money-Creation Formula Is Oversimplified
• Oversimplified money multiplier
– Accurate - very particular circumstances:
1.E...
Money-Creation Formula Is Oversimplified
• If individuals & business firms
– Hold more cash
– Limited
• Multiple expansion...
Money-Creation Formula Is Oversimplified
• If banks
– Keep excess reserves
– Limited
• Multiple expansion of bank deposits...
Banks and Money Creation

• Assumptions
– Each bank
• Holds exactly 20% required reserves

– Each loan recipient
• Redepos...
Figure 3
The chain of multiple deposit creation

33
What is Inflation??
•
•

•

A sustained increase in the general level of prices so
that a given amount of money buys less ...
Types of Inflation
• Demand pull inflation:
This represents a situation where there is increase
in Aggregate Demand for re...
Types of Inflation
• Cost Push inflation: This is because of large
increases in the cost of important goods or services
wh...
Causes of Inflation
• Inflation due to Monetary expansion
(Monetary inflation)
• Inflation due to rise in real aggregate
d...
Monetary inflation
It was Milton Friedman who famously
quipped, “Inflation is always and
everywhere a monetary phenomenon....
Remedies – Monetary Inflation
• If the cause of inflation is instead
monetary expansion, aggregate supply
should still be ...
Remedies - Real Demand Inflation
• It involves inflation rising as the real gross domestic
product rises and unemployment ...
Remedies - Real Demand Inflation
• If aggregate supply is sufficiently stimulated, inflation
may be converted into balance...
Real v/s Money Inflation
To distinguish real demand inflation from
monetary inflation is to look at interest
rates. When i...
The Need for Monetary Policy

• During a recession
– Banks - reduce money supply
• Increase excess reserves
• Decrease len...
The Need for Monetary Policy

• During an economic boom
– Banks – expand money supply
– Undesirable momentum to economy
• ...
What is Monetary Policy??
It is the process by which the central
bank or monetary authority of a country
regulates (i) the...
Monetary policy
Monetary policy is one of the tools used to
control the supply and availability of money,
to influence the...
What is Monetary Policy??

• It is concerned with the changing the supply of
money stock and rate of interest for the purp...
Monetary policy provides
a) an overview of economy
b) specifies measures that RBI intends to
take to influence such
– key ...
Monetary policy & Inflation
• When inflationary pressures build up:
– raise the short-term interest rate (the
policy rate)...
TYPES OF MONETARY POLICY

• Cheap money policy : Followed in
periods of slums & depression
• Dear money policy: Followed i...
Monetary Policy Instruments
•
•
•
•
•
•

Open Market Operations
Bank rate
Cash Reserve Ratio
Statutory Liquidity Ratio
Rep...
Open Market Operations
OMOs are the means of implementing
monetary policy by which a central bank
controls the nation’s mo...
What is the outcome on account of OMO?
• When the RBI buys bonds from the market and infuses
liquidity, the consequences a...
Bank rate
Rate at which Central Bank lends money to commercial
Banks
The bank rate signals the central bank's long-term
ou...
Cash Reserve Ratio
 It refers to the cash which banks have to maintain
with RBI as certain percentage of their demand
and...
Statutory Liquidity Ratio
 It is the percentage of total deposits commercial
banks have to invest in government bonds and...
Meaning of Repo
• The term Repo is used as an abbreviation for
Repurchase Agreement.
• Repo rate is the interest rate at w...
Repo Rate
• In current review of monetary policy Repo rate
6.5% and reverse repo is 5.5%
• If the RBI wants to make it mor...
Reverse Repo
• The rate at which RBI borrows money from the banks
(or banks lend money to the RBI) is termed the
reverse r...
Reverse Repo
• Consequently, banks would have lesser funds to lend
to their customers. This helps stem the flow of excess
...
Importance of Repo & Reverse Repo
• It helps borrower to raise funds at better rates
An SLR surplus and CRR deficit bank c...
What is Monetary Policy??
It is the process by which the central
bank or monetary authority of a country
regulates (i) the...
Monetary policy
Monetary policy is one of the tools used to
control the supply and availability of money,
to influence the...
What is Monetary Policy??

• It is concerned with the changing the supply of
money stock and rate of interest for the purp...
Monetary policy provides
a) an overview of economy
b) specifies measures that RBI intends to
take to influence such
– key ...
Monetary policy & Inflation
• When inflationary pressures build up:
– raise the short-term interest rate (the
policy rate)...
TYPES OF MONETARY POLICY

• Cheap money policy : Followed in
periods of slums & depression
• Dear money policy: Followed i...
Monetary Policy Instruments
•
•
•
•
•
•

Open Market Operations
Bank rate
Cash Reserve Ratio
Statutory Liquidity Ratio
Rep...
Open Market Operations
OMOs are the means of implementing
monetary policy by which a central bank
controls the nation’s mo...
What is the outcome on account of OMO?
• When the RBI buys bonds from the market and infuses
liquidity, the consequences a...
Bank rate
Rate at which Central Bank lends money to commercial
Banks
The bank rate signals the central bank's long-term
ou...
Cash Reserve Ratio
 It refers to the cash which banks have to maintain
with RBI as certain percentage of their demand
and...
Statutory Liquidity Ratio
 It is the percentage of total deposits commercial
banks have to invest in government bonds and...
Meaning of Repo
• The term Repo is used as an abbreviation for
Repurchase Agreement.
• Repo rate is the interest rate at w...
Repo Rate
• In current review of monetary policy Repo rate
6.5% and reverse repo is 5.5%
• If the RBI wants to make it mor...
Reverse Repo
• The rate at which RBI borrows money from the banks
(or banks lend money to the RBI) is termed the
reverse r...
Reverse Repo
• Consequently, banks would have lesser funds to lend
to their customers. This helps stem the flow of excess
...
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The+money+supply

  1. 1. Chapter 12 Money and the Banking System
  2. 2. What is Money Supply? – Money supply is one of the important indicator of macroeconomic environment – This refers to the total volume of money circulating in the economy at a point in time. – Money supply in an economy determines liquidity conditions in the market, which in turn impacts interest rate structure and hence the cost of capital to the firms.
  3. 3. Contd.. – Money supply is basically determined by the central bank of a country (e.g. Reserve Bank of India) and the commercial banking network. – RBI has adopted four measures of money supply viz.Ml, M2, M3 and M4 . – M3 (broad money) is most popular from operational point of view. M3 includes time deposits (fixed deposits), savings deposits with post office saving banks and all the components of M1.
  4. 4. Factors affecting Money supply • • • • • Bank credit Deficit financing Foreign exchange reserves Government Expenditure FII inflows
  5. 5. What cause increase in money supply? gulated?  RBI has the power to print notes, they can hence release more money into the economy.  However it is only partly true. Such a process cannot be sustained as more notes for the same quantity of physical goods in the economy will only bring down the value of the currency and hence will not benefit anyone. After all increase in money supply should be done with an objective to benefit the economy as a whole by protecting the value of the currency. So, a government has to exercise restraint in printing notes.
  6. 6. How Quantity of Money is Measured • Money supply M1 – Narrowly defined – Coins and paper money in circulation – Traveler’s checks – Conventional checking accounts – Certain other checkable deposits • Banks • Savings institutions The RBI employs four measures of money stock, namely M1, M2, M3 and M4. 6
  7. 7. How Quantity of Money is Measured • M1: This is the money supply ie the currency with the public and demand deposits with the bank and other deposits with RBI. • In developed countries demand deposits form a major part of the money supply. Demand deposits are primarily savings and current account deposits where your are able to "demand" your money at any time, unlike a term deposit, which cannot be accessed for a predetermined period (the loan's term). M2: M1+Post Office Savings + balances in money market mutual funds • M3 or aggregate money supply: M2 + Time Deposits with the banks. • M4: M3+total Post office deposits 7
  8. 8. How Quantity of Money is Measured • Near moneys – Liquid assets – Close substitutes for money • Asset’s liquidity – Ease – convert into cash • Credit cards – Not included in money supply • Convention: Money – Coins – Paper money – Checkable deposits 8
  9. 9. The Origins of the Money Supply • Asset - item of value – Owned • Liability - item of value – Owed / Debt • Balance sheet - accounting statement • Left side: values of all assets • Right side: values of all liabilities & net worth – Net worth = assets – liabilities – Assets = Liabilities + Net worth 9
  10. 10. Balance sheet of RBI, December 31, 2011 Assets Financial Assets A) Credit to Government - credit to centre - loans and advances, -TB, dated securities c) Credit to state government d) loans and advances B)CREDIT to Commercial Sector Shares /bonds of FI loans to FI, debentures of cooperatives C RBI gross claims on banks Refinance of RBI fixed investments in commercial banks shares/debentures D)Net foreign ASSETS - gold foreign securities E Other Assets Liabilities and Net Worth Monetary liabilities A)Notes in circulation - other deposits balances with foreign central banks , accounts with IMF Reserves NON Monetary liabilities -Capital Account (net worth) - Paid up capital - Statutory Reserves Miscellaneous - Bills payable, RBI employee fund etc 10
  11. 11. The Origins of the Money Supply • The Monetary liabilities of the RBI are a) Currency issued by RBI b) Reserves held by commercial bank c) Other Deposits with RBI (very small components ) Along with coins issued by government of India makes the Monetary base . • It is Called The High Powered Money • H= C+R • 11
  12. 12. The Origins of the Money Supply RBI Assets= RBI liabilities = (FA)+ OA= ML+NML = FA+OA-NML= ML IF NNML= (NML-OA) Then ML= FA-NNML ∆ H= ∆ML+∆GM Since GM is a very small portion ∆H=∆ML= ∆FA -∆ NNML 12
  13. 13. The Origins of the Money Supply • The Monetary liabilities of the RBI are a) Currency issued by RBI b) Reserves held by commercial bank c) Other Deposits with RBI (very small components ) Along with coins issued by government of India makes the Monetary base . • It is Called The High Powered Money • H= C+R • 13
  14. 14. The Origins of the Money Supply • • • • • Ms = m .H M= money multiplier M= broad money M3= C+DD+TD m= Ms/H H= C+R • M=C+DD+TD/ C+R – equation 1 • R= (DD+TD)r • r = R/DD+TD) • Equation -1 divide by DD • C/DD+1+TD/DD/ C/DD+r(1+TD/DD) = c+1+t/ c+r(1+t) 14
  15. 15. Origins of money supply m= 1+c+t/c+ r(1+t) m= 1+c/c+r without TD If banks hold excess reserves m =1+c/r+c+e And Ms= m H So money supply changes when There is a change in H Change in m but m=f( c+t+r) which are behavioral In short run money supply changes are brought by changes in H. 15
  16. 16. • Some body deposits $1000 in bank A. For simplicity sake, we will show new changes in assets and liabilities only. • The balance sheet of bank A now appears as under.
  17. 17. Process of Credit Creation • A single bank cannot create loan the banking system as a whole can make loans. • The process of credit creation is now explained with the help of an example. • Let us assume that there are more than one banks in the country. It is further assume that the required reserve ratio is 20%.
  18. 18. • “This tendency on the part of the commercial banks to make loans several times of the excess cash reserves kept by the bank is called creation of credit”.
  19. 19. Do Banks Create Credit? • Creation of credit means that the commercial banks by taking in deposits and making loans expand the money supply. • Creation of credit is one of the important functions of commercial banks. • Credit creation is the multiple expansion of banks demand deposits.
  20. 20. Bank A Balance Sheet Assets Liabilities Cash received = $ 1000 Demand Deposits = $1000 We assume now that Mr. X approaches the bank A for a loan. The bank set aside 20% or $200 as required reserve and the balance of $800 is loaned out to Mr. X The Balance sheet of Bank A after giving loan would appear as under.
  21. 21. Bank A Balance Sheet Assets Liabilities Cash received = $ 200 Loan to Mr. X = 800 Total = $1000 Demand Deposits = $1000 _________ Total = $1000 Now We assume that the borrower Mr. X makes a payment of $800 by check to Mr. Y to pay his debt. Mr. Y has account in Bank B and he deposits this amount in his account. The Bank B receives $800 as deposits and its balance sheet now appear as under.
  22. 22. Bank B Balance Sheet Assets Liabilities Cash received = $ 800 Demand Deposits = $800 We further assume that Mr. N approaches the bank B for a loan. The bank set aside 20% or $160 as required reserve and the balance of $640 is loaned out to Mr. N. The Balance sheet of Bank B after giving loan would appear as under.
  23. 23. Bank B Balance Sheet Assets Liabilities Cash received = $ 160 Loan to Mr. N = 640 Total = $800 Demand Deposits = $800 _________ Total = $800 Now We assume that the borrower Mr. N makes a payment of $640 by check to Mr. M to pay his debt. Mr. M has account in Bank C and he deposits this amount in his account. The Balance Sheet of bank C increases by $640.The Bank C also keep 20% as required reserve ($128) and give excess reserve of $512 as loan to Mr. Z.
  24. 24. • The amount loaned out to Mr. Z becomes a new deposits at another bank K. • If the process of creating secondary deposits is continued, then at each stage in this sequence the amount of new loan gets smaller and smaller. • The initial or primary deposit of $1000 with Bank A leads to the secondary deposits of $800 in the first round , $640 in the second round and $512 in third round and so on. • The total increase in deposits from the initial $1000 is $5000.
  25. 25. • The increase is five fold, the reciprocal of the reserve requirement which is shown in the table below.
  26. 26. Example of credit creation by banking system Banks Primary Deposits Cash reserve at 20% Credit Creation A B C D E F G H . . N 1000 800 640 512 409 327 262 209 200 160 128 102 81 65 54 41 800 640 512 409 327 262 209 167 TOTAL 5000 1000 4000
  27. 27. • • • • • The table shows the following points (i) If the cash reserve ratio is 20%and (ii) the initial deposit is $1000 The banks creates newly created money of $4000. The total demand deposits are $5000 (initial deposit $1000 + credit creation $4000 = $5000).
  28. 28. Credit multiplier • The credit expansion in the banking system is influenced by the credit multiplier. • “The credit multiplier is the reciprocal of the required reserve ratio”. • Credit multiplier = 1/required reserve ratio • If reserve ratio is 20% • Then credit multiplier = 1/0.20 = 5
  29. 29. Money-Creation Formula Is Oversimplified • Oversimplified money multiplier – Accurate - very particular circumstances: 1.Every recipient of cash • Must redeposit cash - another bank • Doesn’t hold cash 1.Every bank • Must hold reserves - legal minimum 29
  30. 30. Money-Creation Formula Is Oversimplified • If individuals & business firms – Hold more cash – Limited • Multiple expansion of bank deposits – Fewer dollars of cash • Available for use as reserves – Smaller money supply 30
  31. 31. Money-Creation Formula Is Oversimplified • If banks – Keep excess reserves – Limited • Multiple expansion of bank deposits – Smaller supply of money 31
  32. 32. Banks and Money Creation • Assumptions – Each bank • Holds exactly 20% required reserves – Each loan recipient • Redeposits proceeds - next bank • Sum of infinite geometric progression 1 1 + R + R + R + ... = 1− R 2 3 32
  33. 33. Figure 3 The chain of multiple deposit creation 33
  34. 34. What is Inflation?? • • • A sustained increase in the general level of prices so that a given amount of money buys less and less. In the Keynesian sense True inflation begins when the elasticity of supply of output in response to increase in money supply has fallen to zero or when output is unresponsive to changes in money supply. Opinion survey conducted in India, USA and many other countries reveal that inflation is the most important concern of the people as it badly affects their standard of living.
  35. 35. Types of Inflation • Demand pull inflation: This represents a situation where there is increase in Aggregate Demand for resources either from the government or the entrepreneurs or the households. Result of this is that the pressure of Demand can’t be met by the Currently available Aggregate Supply which result in Aggregate Demand > Aggregate Supply which is bound to generate inflationary pressure in the economy.
  36. 36. Types of Inflation • Cost Push inflation: This is because of large increases in the cost of important goods or services where no suitable alternative is available. This may happen if the costs especially wage cost rise. • Hyperinflation: Hyperinflation is also known as runaway inflation or galloping inflation. This type of inflation occurs during or soon after a war
  37. 37. Causes of Inflation • Inflation due to Monetary expansion (Monetary inflation) • Inflation due to rise in real aggregate demand (Real inflation) • Inflation due to contraction in Aggregate Supply
  38. 38. Monetary inflation It was Milton Friedman who famously quipped, “Inflation is always and everywhere a monetary phenomenon.” If the quantity of money grows at a pace greater than warranted by the growth of the economy, then the excess money supply drives up prices.
  39. 39. Remedies – Monetary Inflation • If the cause of inflation is instead monetary expansion, aggregate supply should still be stimulated, but the focus of effort should be constraining further monetary expansion.
  40. 40. Remedies - Real Demand Inflation • It involves inflation rising as the real gross domestic product rises and unemployment falls • If inflation is caused by strong real demand, the best response may be to support aggregate supply growth. Part of the solution may be to let prices rise. Suppliers need incentives to invest in new capacity. • Stimulating aggregate supply include encouraging business investment; reducing input costs; and increasing competitive intensity.
  41. 41. Remedies - Real Demand Inflation • If aggregate supply is sufficiently stimulated, inflation may be converted into balanced economic growth: • If instead money supply is tightened in the face of strong real demand, the result will be a surge in interest rates, which may be counterproductive in this case, as it will be harder for aggregate supply to expand when borrowing costs are high.
  42. 42. Real v/s Money Inflation To distinguish real demand inflation from monetary inflation is to look at interest rates. When inflation is caused by strong real demand, interest rates will tend to be high. When inflation is caused by excessive monetary growth, in contrast, interest rates will tend to be low.
  43. 43. The Need for Monetary Policy • During a recession – Banks - reduce money supply • Increase excess reserves • Decrease lending – Less creditworthy applicants – Aggravate recession – Need government intervention 43
  44. 44. The Need for Monetary Policy • During an economic boom – Banks – expand money supply – Undesirable momentum to economy • Inflation – Need government intervention 44
  45. 45. What is Monetary Policy?? It is the process by which the central bank or monetary authority of a country regulates (i) the supply of money (ii) availability of money and (iii) cost of money or rate of interest in order to attain a set of objectives oriented towards the growth and stability of the economy
  46. 46. Monetary policy Monetary policy is one of the tools used to control the supply and availability of money, to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability" - low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed "Central Bank“.
  47. 47. What is Monetary Policy?? • It is concerned with the changing the supply of money stock and rate of interest for the purpose of stabilizing the economy by influencing the level of aggregate demand. • At times of recession monetary policy involves the adoption of some monetary tools which tends to increase the money supply and lower interest rate so as to stimulate aggregate demand in the economy. • At the time of inflation monetary policy seeks to contract aggregate spending by tightening the money supply or raising the rate of return.
  48. 48. Monetary policy provides a) an overview of economy b) specifies measures that RBI intends to take to influence such – key factors like…money supply….interest rates….inflation c) lays down norms for financial institutions like banks, financial companies etc. relating to CRR, capital adequacy
  49. 49. Monetary policy & Inflation • When inflationary pressures build up: – raise the short-term interest rate (the policy rate) – which squeezes consumption and investment.
  50. 50. TYPES OF MONETARY POLICY • Cheap money policy : Followed in periods of slums & depression • Dear money policy: Followed in periods of boom & inflation.
  51. 51. Monetary Policy Instruments • • • • • • Open Market Operations Bank rate Cash Reserve Ratio Statutory Liquidity Ratio Repo rate Reverse Repo rate
  52. 52. Open Market Operations OMOs are the means of implementing monetary policy by which a central bank controls the nation’s money supply by buying and selling government securities, or other financial instruments
  53. 53. What is the outcome on account of OMO? • When the RBI buys bonds from the market and infuses liquidity, the consequences are: – It tends to soften the interest rates – It enables corporate to borrow at favorable interest rates – It may tend to increase inflation • Consequently… If the RBI were to sell bonds instead and suck in liquidity, the effect would exactly be the opposite!!
  54. 54. Bank rate Rate at which Central Bank lends money to commercial Banks The bank rate signals the central bank's long-term outlook on interest rates. If the bank rate moves up, long-term interest rates also tend to move up, and viceversa. Any increase in Bank rate results in an increase in interest rate charged by Commercial banks which in turn leads to low level of investment and low inflation
  55. 55. Cash Reserve Ratio  It refers to the cash which banks have to maintain with RBI as certain percentage of their demand and time liabilities  An increase in CRR reduces the cash with commercial banks which results in low supply of currency in the market, higher interest rate and low inflation
  56. 56. Statutory Liquidity Ratio  It is the percentage of total deposits commercial banks have to invest in government bonds and other approved securities. RBI in November cut the SLR for banks by one percentage point and it now stands at 24% of their total demand and time deposit liabilities  Objectives of SLR – To restrict expansion of Bank credit – To augment bank’s investment in government securities – To ensure solvency of banks
  57. 57. Meaning of Repo • The term Repo is used as an abbreviation for Repurchase Agreement. • Repo rate is the interest rate at which the central bank lends funds to banks against pledging securities • It enables collateralized short term borrowing and lending through sale/purchase operations in debt instruments
  58. 58. Repo Rate • In current review of monetary policy Repo rate 6.5% and reverse repo is 5.5% • If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.
  59. 59. Reverse Repo • The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the reverse repo rate. • If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk)
  60. 60. Reverse Repo • Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy • Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is injected.
  61. 61. Importance of Repo & Reverse Repo • It helps borrower to raise funds at better rates An SLR surplus and CRR deficit bank can use the Repo deals as a convenient way of adjusting SLR/CRR positions simultaneously. • RBI uses Repo and Reverse repo as instruments for liquidity adjustment in the system • Reverse Repo is undertaken to earn additional income on idle cash.
  62. 62. What is Monetary Policy?? It is the process by which the central bank or monetary authority of a country regulates (i) the supply of money (ii) availability of money and (iii) cost of money or rate of interest in order to attain a set of objectives oriented towards the growth and stability of the economy
  63. 63. Monetary policy Monetary policy is one of the tools used to control the supply and availability of money, to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability" - low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed "Central Bank“.
  64. 64. What is Monetary Policy?? • It is concerned with the changing the supply of money stock and rate of interest for the purpose of stabilizing the economy by influencing the level of aggregate demand. • At times of recession monetary policy involves the adoption of some monetary tools which tends to increase the money supply and lower interest rate so as to stimulate aggregate demand in the economy. • At the time of inflation monetary policy seeks to contract aggregate spending by tightening the money supply or raising the rate of return.
  65. 65. Monetary policy provides a) an overview of economy b) specifies measures that RBI intends to take to influence such – key factors like…money supply….interest rates….inflation c) lays down norms for financial institutions like banks, financial companies etc. relating to CRR, capital adequacy
  66. 66. Monetary policy & Inflation • When inflationary pressures build up: – raise the short-term interest rate (the policy rate) – which squeezes consumption and investment.
  67. 67. TYPES OF MONETARY POLICY • Cheap money policy : Followed in periods of slums & depression • Dear money policy: Followed in periods of boom & inflation.
  68. 68. Monetary Policy Instruments • • • • • • Open Market Operations Bank rate Cash Reserve Ratio Statutory Liquidity Ratio Repo rate Reverse Repo rate
  69. 69. Open Market Operations OMOs are the means of implementing monetary policy by which a central bank controls the nation’s money supply by buying and selling government securities, or other financial instruments
  70. 70. What is the outcome on account of OMO? • When the RBI buys bonds from the market and infuses liquidity, the consequences are: – It tends to soften the interest rates – It enables corporate to borrow at favorable interest rates – It may tend to increase inflation • Consequently… If the RBI were to sell bonds instead and suck in liquidity, the effect would exactly be the opposite!!
  71. 71. Bank rate Rate at which Central Bank lends money to commercial Banks The bank rate signals the central bank's long-term outlook on interest rates. If the bank rate moves up, long-term interest rates also tend to move up, and viceversa. Any increase in Bank rate results in an increase in interest rate charged by Commercial banks which in turn leads to low level of investment and low inflation
  72. 72. Cash Reserve Ratio  It refers to the cash which banks have to maintain with RBI as certain percentage of their demand and time liabilities  An increase in CRR reduces the cash with commercial banks which results in low supply of currency in the market, higher interest rate and low inflation
  73. 73. Statutory Liquidity Ratio  It is the percentage of total deposits commercial banks have to invest in government bonds and other approved securities. RBI in November cut the SLR for banks by one percentage point and it now stands at 24% of their total demand and time deposit liabilities  Objectives of SLR – To restrict expansion of Bank credit – To augment bank’s investment in government securities – To ensure solvency of banks
  74. 74. Meaning of Repo • The term Repo is used as an abbreviation for Repurchase Agreement. • Repo rate is the interest rate at which the central bank lends funds to banks against pledging securities • It enables collateralized short term borrowing and lending through sale/purchase operations in debt instruments
  75. 75. Repo Rate • In current review of monetary policy Repo rate 6.5% and reverse repo is 5.5% • If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.
  76. 76. Reverse Repo • The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the reverse repo rate. • If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk)
  77. 77. Reverse Repo • Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy • Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is injected.
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