Money Market

(Money and Banking)

T.J. Joseph
 What is Money?
A financial asset with the following functions:
Medium of exchange:
An asset that individuals acquire for the purpose of
trading rather than for their own consumption.
A store of value:
Means of holding purchasing power over time
A unit of account:
Measure used to set prices and make economic
calculations
2
What is money?
Most liquid
Money is anything Currency
that serves as a Transaction
commonly accepted deposits
medium of exchange
Very liquid
Saving deposits
Money and Income
What we earn is income, Short-term
not money securities
Money is used to pay the Money-market
income
funds
Less liquid
 Money Supply
Narrow (Transactions) Money (M1) =
Coins and paper currency + Demand Deposits (or
Checkable Deposit), Traveler’s Checks, etc.
(‘Other’ deposits with RBI (= deposits of UTI, IDBI etc; deposits of foreign
central banks/governments etc.) are also a part of M1; statistically very small)

Broad Money (M3) = M1 + time deposits with banks

(Money supply in India usually refers to M3)
Also:
M2 (Near-Money) = M1 + savings deposits of post office
savings bank
M4 = M3 + total deposits with post office savings banks
 M1: Rs 1253184 crores, March 2009
Currency with the public Demand deposits
‘Other’ deposits with the RBI

1%

46%
53%

5
M3: Rs 4764019 crores, March 2009
Currency with the public Demand deposits
Time deposits ‘Other’ deposits with the RBI
0%
14%

12%

74%

6
Who Determines Money Supply?
Central Bank (RBI):
– Determines the monetary base (also known as
reserve money, base money, high powered
money etc.) by fixing the cash reserve ratio, bank
rate, etc.
Commercial Banks:
– Create money through multiple expansion of
bank deposits based on cash reserves (credit
money)
General Public:
 Central Bank
Central Bank (Reserve Bank of India, Federal
Reserve System in USA) oversees and regulates
the banking system and controls the money
supply by determining the monetary base
Three primary functions of the Central Bank:
1) Regulates banks to ensure they follow the
laws intended to promote safe and sound
banking practices.
2) Acts as a banker’s bank, making loans to banks
and as a lender of last resort.
 Banking and Supply of Money
The Process of Deposit Creation

Commercial Banks are important source of money

supply

The money they supply is called Credit money

Banks receive deposits from the public

 Banking and Supply of Money
Primary Deposits
i) Savings deposited for the sake of safety
ii) Payment received from the central bank for sale
of govt. bond
iii) Payment received from abroad and deposited
with the bank
iv) For the convenience in receiving and making
payments
Deposit Creation
The process of credit creation or deposit creation begins with
banks lending money out of primary deposits
Statutory Reserve Requirements: Portion of primary deposits
to be maintained either as (i) ‘Cash Reserve’ (CRR) with the
Central Bank, or (ii) ‘excess reserve’ (Statutory Liquidity
Ratio (SLR)) to meet the cash demand by the depositors
Deposit Creation in a Single Bank System
Assume:
– There is a single bank
– Accepts only demand deposits
– SRR is 20% (CRR of 5% and SLR of 15%)
– Assets of the bank are CRs and loans & advances
Suppose an individual A deposits Rs.1000 with the bank
All deposits with the bank are its liability
The change in the balance sheet of bank is given as:

Liabilities Amount Assets Amount

A’s deposit 1000 SRR 200

Loans & Investments 800

Total 1000 Total 1000

The bank will lend the Rs.800 other than the reserve
requirements
Suppose an individual, B borrow this money. The bank may
handover the entire Rs.800 to B or open an account in his
name and credit the amount to that account
Suppose B keeps the money safe in the bank and to make
payments by cheques whenever he needs
Now, bank’s deposits increase by Rs.800 and SRR is Rs.160
(20% of 800). Now,
Liabilities Amount Assets Amount
A’s deposit 1000 SRR (200+160) 360
B’s deposit 800 Loan to B 800
Excess cash reserves 640
Total 1800 Total 1800

Note, the bank has excess cash reserves of Rs.640 now

The process of borrowing and lending repeated again.
Suppose the bank lends Rs.640 to another individual, C, and
credits the money to his account
The balance sheet of the bank now is:

Liabilities Amount Assets Amount

A’s deposit 1000 SRR (200+160+128) 488
B’s deposit 800 Loan to B 800
C’s deposit 640 Loan to C 640
Excess cash reserves 512
Total 2440 Total 2440

This process of borrowing and lending is called the process

of credit creation or the process of deposit creation
This process of deposit and credit creation continues until the
excess cash reserve is reduced to zero, provided no other
primary deposits are made
Liabilities Amount Assets Amount
A’s deposit 1000 SRR (200+160+128) 488
B’s deposit 800 Loan to B 800
C’s deposit 640 Loan to C 640
------ ----- ------ -----
------ ----- ------ -----
nth deposit 000 Excess cash reserves 000
Total 5000 Total 5000

Note that a primary deposit of Rs.1000 leads to the creation of a

total deposit of Rs.5000.
Thus, the deposit multiplier equals 5
Deposit Creation in Multiple Banking System
The system works as the same in the case of a single
banking system if the person who receive the money keeps
it as demand deposits
Thus, on the basis of Rs.1000 deposits, the commercial
banking system is able to lend by a multiple of 5, when the
reserve requirement is 20%
The chain of increase in deposits will be as follows:
1000 + 800 + 640 + ………..
This is a geometric series and the sum will be equal to
1000
 5000
0 .20
Enabling factors
The process of multiple expansion deposits has been
possible because that what one bank losses is another
bank gains
Banks are able to keep only a fraction of the deposits in
cash – why?
– (i) No depositor withdraws full amount of his deposit
– (ii) When depositors draws cheques on their accounts it is
not necessary that banks pass out cash to that extent
Thus, there are two types of bank deposits
– Primary deposit → customers deposit money
– Secondary deposits → through the process of lending
Limits on deposit creation

Banks do not have infinite capacity to create

deposits because of three limitations
(i) The amount of cash that banks have to maintain against
the deposits (with the central bank and also to meet the
requirements of depositors)

(ii) Cash drain or cash leakage. This depends on how

widespread the use of cheques in the economy is.

(iii) Banks inability to find borrowers

 Money Multiplier Approach
Monetary liabilities of RBI:
– Currency issued by the RBI (notes of rupees two and above)
– Reserves held by the commercial banks with the RBI, and
– Other deposits with the RBI
Central Government also issues money in the form of one-
rupee notes, coins and small coins (the share is negligible)
 Money Multiplier Approach
The monetary liabilities of the RBI plus Government money is
known as ‘High Powered Money’ (H), also called ‘Reserve
Money’ or ‘Monetary Base’
Therefore, H = currency with the public (C) + Reserves (R) +
Other deposits with the RBI
Neglecting other deposits with the RBI, H = C + R
 Money Multiplier
The monetary base is the sum of currency in circulation and
cash reserves of banks (cash in vaults plus deposits with RBI)
It is different from the money supply, bank deposits plus
currency in circulation. Each rupee of bank reserves backs
several rupees of bank deposits, making the money supply
larger than the monetary base.

The money multiplier is

the ratio of the money
supply to the monetary
base.
 Money Multiplier Approach
Reserves (R) = Vault Cash + Banks’ deposits with the RBI
= Statutory reserves + Excess reserves
The currency and coins with the commercial banks (in order to
meet the business needs of the bank) is treated as ‘Vault Cash’
(It is equal to the Statutory Liquidity Reserve)
Money multiplier equation is
Ms = m.H
where, Ms = money supply (M1, M2 or M3), m = money multiplier,
H = high powered money
That is, the total supply of money (Ms) depends on the supply of
the high-power money (H) and the money multiplier (m)
 Money Multiplier Approach
Now, Money Multiplier, m = Ms / H
Suppose Ms = M1 = C + DD
Where, C = currency in circulation
DD = demand deposits
Reserves, R = r.DD,
where, reserve ratio, r = R / DD
Now, m = Ms / H = (C+DD) / (C+R)
Suppose Ms = M3 = C + DD + TD
Where TD = time deposits
Now, m = M3 / H = (C+DD+TD) / (C+R)
Role of General Public in Money Supply
How to know money supply over a period of
time?
Velocity of circulation of money – the number
of times money changes hands
Therefore, supply of money over a period of
time = the amount of money * velocity of
circulation
For practical point, we divide the national
income by money supply to obtain the income
velocity of circulation of money
Equation of exchange
During any period the total value of transactions must be the
same as the total value of money exchanged
Total value of transactions equal total goods and services
traded (T) multiplied by their average price (P)
Total value of money exchanged equal the amount of money
(M) multiplied by the velocity of circulation (V).
Equating what is paid and what is received,
MV = PT → equation of exchange
Replacing T with real NI, Y, we get
MV = PY
 Money Supply
How does money supply affect GDP?
The value of the GDP is nothing but the sum
total of all the transactions (given by the
velocity of money) over a period of time
GDP, therefore, depends on the stock of money
multiplied by the speed with which money
changes hands
As the stock of money increases, more goods
and services will be exchanged and the GDP will
rise (a stimulative role)
 Money Demand

Money demand is determined by several factors.

 According to the theory of liquidity
preference, one of the most important factors
is the interest rate.
 People choose to hold money because money
can be used to buy other goods and services.
 Demand for Money
Reasons for Money Demand
(1) Transactions Demand for Money
That is, to buy goods and services
It is a positive function of income (GDP) –
Higher income higher the demand for money
to buy goods and services
But it is also a negative function of interest
rate
(2) Precautionary Demand for Money
Hold money to meet unforeseen emergencies
 Demand for Money
(3) Speculative Demand for Money
Holding money to make capital gains or avoid
capital losses
It depends on the people’s expectation about
bond prices
If the current bond prices are low and expected
to rise, people will hold less money and buy
more bonds (speculative demand for money is
low) and vice versa.
Conclusion
 Interest Rates: The Price of Money
Interest is the payment made for the use of
money
or the price paid to borrow money
Costs of Holding Money
 The opportunity cost of holding money is the
interest that you would have earned if you
invested it
 An increase in the interest rate raises the
opportunity cost of holding money.
 Interest Rates: The Price of Money
Nominal and Real Interest Rates
Nominal interest rate measures the yield in
rupees per year per rupee invested (it is the
money value)
It does not take into account the changes in
the prices or inflation factor
Real interest rate is corrected for inflation
It is calculated as the nominal interest rate
minus rate of inflation
 Equilibrium in the Money Market
Interest
Rate
Money
supply

r1

Equilibrium
interest rate

r2
Money
demand

0 Md1 Quantity fixed d Quantity of

M 2
by the RBI Money
 Changes in the Money Supply
 The RBI can shift the aggregate demand curve
when it changes monetary policy.
 An increase in the money supply shifts the
money supply curve to the right.
 Without a change in the money demand curve,
the interest rate falls.
 Falling interest rates increase the quantity of
goods and services demanded.
 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

A Monetary Injection...
(a) The Money Market (b) The Aggregate-Demand Curve

Interest Money MS2 Price 3. …which

Rate supply, Level increases the
MS1 quantity of goods
1. When and services
the RBI demanded at a
increases
the money given price level.
supply… P
r1

r2 AD2

Aggregate demand,
AD1
0 Quantity 0 Y1 Y2 Quantity
2. …the equilibrium of Money of Output
interest rate falls…
MONETARY POLICY
 Monetary Policy
How does a monetary authority decide on when to
expand or contract credit and by how much?

Decision based on the overall objectives of the

monetary policy
 Meaning of Monetary Policy
“Monetary policy is essentially a programme of action
undertaken by the monetary authorities, generally the
central bank, to control and regulate the supply of
money with the public and the flow of credit with a view
to achieving predetermined macroeconomic goals”

The objectives of monetary policy are the same as of

macroeconomic policy – price stability, currency stability,
financial stability, growth in employment and income
 Money Supply
 The money supply is controlled by the RBI
through:
 Changing the reserve requirements
 Changing the bank rate
 Open-market operations
 Thus the quantity of money supplied does not
depend on the interest rate and is vertical.
 Instruments of Monetary Policy
Credit Control by the Central Bank
Instruments of credit control
Broadly categorized into two:
– General instruments are intended to regulate the total
volume of credit (quantitative)
Include (1) bank rate, (2) open market operations,
(3) power to vary the reserve requirements
– Selective instruments to regulate the purpose for which
commercial banks generated credit (qualitative)
 Variable Reserve Ratios
Banks are required to maintain a percentage of
their deposits in the form of balances with the
RBI, known as legal reserve requirement
(statutory reserve requirement)
RBI has the power to vary this ratio and used
as an instrument of credit control
An increase in reserve requirement ratio will
reduce the reserves for lending by the banks
A lowering of the reserve ratio will enable the
banks to expand credit
 Bank Rate
The minimum rate at which the central bank
of a country provided financial assistance to
commercial banks

By raising or lowering bank rate, the central

bank can reduce or expand credit granted by
banks

Currently bank rate in India is 6.0%

 Bank Rate
How bank rate works?
↑ bank rate → ↑ cost of borrowing by
commercial banks from the central bank → ↑
in lending rate of commercial banks → less
borrowing
Adverse effect on the level of production and
prices
Usually used during inflationary situation
Similarly, a fall in bank rate lower the lending
Conditions for successful working of bank rate
A well organized money market in order to have impact
on other rates in the market
Reactions of borrowers to change in the lending rates
A fall in output may coexist with a rise in price
Customers’ assessment of the economic situation. If the
business conditions are not favorable lowering of lending
rate may not attract much borrowers
Bank Rate in India
 Policy Rates
(www.rbi.org.in, 07/06/2010)

Bank rate 6%
Repo rate 5.25 %
Reverse repo rate 3.75 %

Repo (from the perspective of the seller of a security) or Reverse

repo (from the perspective of the buyer of a security) is a
Repurchase agreement in which two parties agree to sell and
repurchase a security on an agreed date at a predetermined price.
When banks sell securities, repo rate is applicable; when banks buy
securities to park surplus funds, reverse repo rate is applicable.
 Reserve Ratios
(www.rbi.org.in, 07/06/2010)

Cash Reserve ratio 6%

Statutory Liquidity ratio 25 %

 Open Market Operations
Primary instrument of credit control in developed markets
Involve the purchase and sale of securities by the central
bank
The purchase of securities by a central bank leads to an
increase in the bank reserves
This leads to a multiple expansion of credit and deposits
On the other hand sale of securities by the central bank
will reduce bank reserves and lead to multiple contraction
of credit
This is not used as an instrument of credit control in India,
because this market is very narrow in India
 Selective Credit Controls
Purpose is to regulate the flow of credit for
financing specific activities
RBI encourages the flow of credit to agriculture
and to other sectors like export
For borrowings of CBs to refinance such
operations RBI charges a lower interest rate
than the bank rate
The ultimate objective is to prevent a rise in the
price of these commodities with the help of
bank credit
 The Effects of Money on Output and
Prices
Transmission Mechanism of Monetary Policy
Suppose RBI is concerned about inflation and
has decided to slow down the economy
Step 1: Suppose RBI reduces reserves with the
banks through any of its credit control activity
Step 2: Reduction in bank reserves result in a
multiple contraction in deposit or credit
creation, thereby reducing the money supply
 The Effects of Money on Output and
Prices
Step 3: Reduction in money supply increases
interest rates and tightens credit conditions,
and lowers the value of people’s assets
Step 4: With higher interest rates and lower
wealth, investment falls. It may raise the
exchange rate of the currency, depressing net
exports
Step 5: Tight money leads to reduced aggregate
demand, reduces income, output, jobs and
 In short……
In a fully employed economy, the higher
money supply would be chasing the same
amount of output and would therefore mainly
end up raising prices

That is, in the long run, prices and wages are

more flexible, and money supply changes tend
to have a larger impact on prices and a smaller
impact on output
 Inflation and interest rate
If both lenders and borrowers expect inflation over
the term of a loan . .

Lenders will demand a higher rate because the

money repaid will have less purchasing power
than the money they lend now

Borrowers will willingly pay a higher rate

because they know it will be easier to earn the
needed money later than it is now
 Videos
http://www.moneycontrol.com/video/economy/monet
ary-tightening-may-not-help-tame-inflationeco-
advisor_434618.html
http://economictimes.indiatimes.com/Chetan-Ahya-
reviews-RBI-monetary-
policy/videoshow/5162691.cms
http://economictimes.indiatimes.com/Need-to-
coordinate-monetary-and-fiscal-policy-D-
Subbarao/videoshow/4893491.cms
Thank You