The+money+supply

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 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.

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.

Factors affecting Money supply
•
•
•
•
•

Bank credit
Deficit financing
Foreign exchange reserves
Government Expenditure
FII inflows

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.

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

• 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

• 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

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

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


• 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

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


• 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

•
•
•
•
•

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

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

• 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.

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%.

• “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”.

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.

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.

Bank A Balance Sheet
Assets

Liabilities

Loan to Mr. X = 800
Total
= $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.

Bank B Balance Sheet
Assets

Liabilities



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.

Bank B Balance Sheet
Assets

Liabilities

Loan to Mr. N = 640
Total
= $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.

• 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.

• 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
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

•
•
•
•
•

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).

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

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

• 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

• If banks
– Keep excess reserves
– Limited
• Multiple expansion of bank deposits

– Smaller supply of money

31

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

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 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.

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.

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

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

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.

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.

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.

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.

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.

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

The Need for Monetary Policy

• During an economic boom
– Banks – expand money supply
– Undesirable momentum to economy
• Inflation

– Need government intervention

44

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

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“.

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.

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

Monetary policy & Inflation
• When inflationary pressures build up:
– raise the short-term interest rate (the
policy rate)
– which squeezes consumption and
investment.

TYPES OF MONETARY POLICY

• Cheap money policy : Followed in
periods of slums & depression
• Dear money policy: Followed in
periods of boom & inflation.

Monetary Policy Instruments
•
•
•
•
•
•

Open Market Operations
Bank rate
Cash Reserve Ratio
Statutory Liquidity Ratio
Repo rate
Reverse Repo rate

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

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!!

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

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

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

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

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.

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)

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.

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.

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