ECONOMICS Chapter 5

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ECONOMICS Chapter 5

  1. 1. Money Supply and Banking System 1 Chapter – 5 Money Supply and Banking
  2. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 13. Money Supply and Banking System13 Determinants of Money Supply  The behavior of the public  Commercial Bank Behavior  Reserves Bank Influence  Other Factors
  14. 14. Money Supply and Banking System14 Equilibrium in Money Market Real Money Balances InterestRate B A E r1 r0 L0 LL
  15. 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. 16. Money Supply and Banking System16 A Fall in the Money Supply Real Money Balances InterestRate E0 r1 r0 E’ LL L1 L0
  17. 17. Money Supply and Banking System17 Increase in Real Income Real Money Balances InterestRate E0 r1 r0 E’ LL L0 LL1
  18. 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.

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