Money Supply And Banking

1. Money Supply and Banking System 1
Chapter – 5
Money Supply and
Banking

2. Money Supply and Banking System2
Objectives of the Session
 To understand money supply and its
components
 To know about the measures of monetary
aggregates
 To understand the creation of money and
banking system
 To know about equilibrium in Money
markets

3. Money Supply and Banking System3
Introduction
 Monetary policy is concerned with the
supply of money in the economy and costs
of borrowing it.
 Money is as money does.
 The value of money is derived in the same
way as the value of any other commodity is
derived.

4. Money Supply and Banking System4
Money Supply –
Components
 Determining what should be included in the
money supply is not as easy as it appears.
 Money is something defined as anything
generally acceptable as a medium of
exchange.
 The means of transferring bank deposit from
one person to another i.e. cheques - are not
money.

5. Money Supply and Banking System5
The Measurement of
Monetary Aggregates
 Since July, 1935, the concept of money supply as
compiled by the RBI was the sum of currency with
the public and demand deposit with me the banking
system.
 This came to be known as ‘narrow money’ and
represented as M1.
 The concept of ‘broad money’, also referred to as
Aggregate Monetary Resources, equivalent to the
sum of M1 and the time deposits with the
commercial banks was first introduced in the
financial year 1964-65.

6. Money Supply and Banking System6
The Measurement of
Monetary Aggregates
M1: Currency with the public + demand
deposits with banks + other deposits with
RBI
M2: M1+ Post Office Savings Deposits
M3: M1+ Time Deposits with banks
M4: M3+ All Post Office Deposits (excluding
national savings certificates)

7. Money Supply and Banking System7
The Money multiplier Approach
 The analysis of balance sheet of the RBI
will give us an insight of its monetary
liabilities, since these liabilities are created
in the process of generating matching
assets by the RBI.

8. Money Supply and Banking System8
The Balance Sheet of the RBI
 With respect to the RBI Balance Sheet it is
to noted that the dated securities of the
Central Government include marketable
securities, special securities, special non-
interest bearing securities and gold bonds.
 Considering the Government’s currency
liabilities to the public, the RBI acts as an
agent in the issue, distribution and handling
of such coins.

9. Money Supply and Banking System9
High Powered
Money
High Power Money (H)
= Monetary liabilities of the RBI + Government
money
= Currency with the public (C) + Reserves (R) +
Other Deposits with the RBI
= C + R
Where, Reserves (R)
= Vault Cash + Banks’ Deposits with the RBI
= Statutory reserves + Excess reserves

10. Money Supply and Banking System10
The Balance Sheet Approach
or The Structural Approach
 This approach is based on the balance sheet of
the consolidated banking sector rather than of the
RBI as in the money multiplier approach.
 The broad money (M3) comprises of the monetary
liabilities of the consolidated banking sector, it
follow from the asset side that:
M3 = Net Banking credit to the Governments
+ Bank Credit to the Commercial Sector
+ Net Foreign Exchange Assets of Banking
Sector
+ Government Currency Liabilities to the Public
– Net Non-monetary of the Banking Sector

11. Money Supply and Banking System11
Creation of Money and
Banking System
 Changes in money supply arise out of the action
of the treasury, Central Bank.
 Banks acquire assets of various kinds, and issue
in payment liabilities on debts, payable at
demand, that are in monetary form and reality and
generally acceptable in the settlement of debts
and payments.
 The RBI has the sole right to issue currency notes
except on rupee notes.
 The commercial banks are creators of the largest
element of the money supply, namely, demand
deposits.

12. Money Supply and Banking System12
Creation of Money and
Banking System
 Commercial Banks: Balance Sheet
 Credit Creation
 Clearing Cheques
 Granting a loan
 Buying government securities
 Multiple Expansion

13. Money Supply and Banking System13
Determinants of Money
Supply
 The behavior of the public
 Commercial Bank Behavior
 Reserves Bank Influence
 Other Factors

14. Money Supply and Banking System14
Equilibrium in Money Market
Real Money Balances
InterestRate
B
A
E
r1
r0
L0
LL

15. Money Supply and Banking System15
Changes in Equilibrium
 A shift in either in supply curve or the
demand curve for the money will alter the
equilibrium position in the money market as
 A Fall in the Money Supply
 Increase in Real income

16. Money Supply and Banking System16
A Fall in the Money Supply
Real Money Balances
InterestRate
E0
r1
r0
E’
LL
L1 L0

17. Money Supply and Banking System17
Increase in Real Income
Real Money Balances
InterestRate
E0
r1
r0
E’
LL
L0
LL1

18. Money Supply and Banking System18
Financial Development
 A well developed financial system is very
essential for the smooth functioning of any
economy.
 An economy can be broadly divided into financial
and non-financial sectors.
 Financial sector consists of banks and other
financial institutions.
 Non-financial sector consists of household,
private corporate business, government and the
rest of the world.