MONEY AND MONEY MARKET

UNIT 1: DEMAND OF MONEY

➢ MONEY - MEANING
• It refers to assets commonly used and accepted as a means
of payment or as a medium of exchange or of transferring
purchasing power without any cost.
• Anything that would act as a medium of exchange is not
necessarily money.

➢ FUNCTIONS OF MONEY
• Money act as a medium of exchange
• Money act as an instrument that facilitates easy exchange of goods
and services.
• Money functions as a common measure of value.
• Money serves as a unit or standard of deferred payment (future
payment)
• Money act as a value of store
• Money functions as a source of purchasing power
• Money also functions as a permanent store of value.

➢ ESSENTIAL CHARACTERISTICS OF MONEY

• Acceptable
• Durable
• Recognizable without
• Difficult to counterfeit
• Relatively scarce
• Portable
• Possessing uniformity
• Divisible

➢ DEMAND FOR MONEY

• Demand for money means how much wealth should be in the form
of money.
• Demand for money depends on many factors, illustrative list is
given: (a) Income – Directly related
(b) Price level – Directly related
(c) Rate of interest – Inversely related
(d) Real GDP – Directly related
(e) Degree of financial innovations – Inversely related
➢ THEORIES FOR DEMAND OF MONEY
(a) Classical approach: The quantity theory of
money
(b) The neo classical approach: The Cambridge
approach
(c) Keynesian theory
(d) Investment approach to transaction
balance
(e) Friedman’s restatement of the quantity
theory
(f) The demand for money as behaviour towards
risk

(A) THE QUANTITY THEORY OF MONEY (BY FISHER)

It is also known as cash transaction approach. As per this approach,
people demand money for transaction purpose. It means demand of
money is depends on price level and numbe r of transaction. Fisher has
explained his theory in terms of his equation of exchange which is as
follows:
MV + M’V’= PT
Where: M = The amount of money in
circulation in an economy
(average) V = Transaction velocity
of circulation
M’ = The total
quantity of credit
money V’ = Velocity
of circulation of
credit money P =
Average price level
T = Total amount of goods and services exchanged for money
The total volume of transactions (T) multiplied by the price level (P)
represents the demand for money. The demand for money (PT) is
equal to the supply of money (MV + M'V)'. In any given period, the total
value of transactions made is equal to PT and the value of money flow
is equal to MV+ M'V'. Thus, there is an aggregate demand for money for
transactions purpose and more the number of transactions people want,
greater will be the demand for money.
As per Fisher ‘Other things remaining same, quantity of money is the
main determinant of price level or the value of money’. If the quantity of
money is doubled, the price level will also double and the value of
money will be one half. If the quantity of money is reduced by one half,
the price level will also be reduced by one half and the value of money will
be twice.

(B) CASH BALANCE APPROACH (MARSHALL, PIGOU, ROBERTSON,

KEYNES)
Cash balance approach considers the demand for money not as a
medium of exchange but as a store of value. The demand for money is
the demand to hold cash for two purposes:
(a) Transaction
purpose
(b) Precautionary
purpose
 Demand of money depends partly on income and partly on other factors of
which important ones are wealth and interest rates. The former
determinant of demand i.e. income, points to transactions demand such
that higher the income, the greater the quantity of purchases and as a
consequence greater will be the need for money as a temporary abode of
value to overcome transactions costs.
The Cambridge equation is stated
as:
Md = k PY

Where Md =
demand for
money PY =
National
income
K = proportion of nominal income that people wants to hold as cash
balance

The Cambridge equation shows that given the supply of money at a point of
time, the value of money is determined by the demand for cash balance.
When the demand for money increases, people will reduce their
expenditure on goods and services in order to have larger cash holding,
reduced demand for goods and services will bring down the price level and
raise the value of money. On the contrary, fall in the demand for money will
raise the price level and lower the value of money.

(C) KEYNESIAN THEORY OF DEMAND OF MONEY

According to Keynes, people hold money (M) in cash for three
motives:
(a) Transactions
motive,
(b) Precautionary motive,
and
(c) Speculative
motive.
The sum of the transaction, precautionary, and the speculative demand,
is the total demand for money. An increase in income increases
the transaction and precautionary demand for money and a decrease in
the rate of interest increases the speculative demand of money.

The transaction motive

The transactions motive for holding cash relates to the need for cash for
current transactions for personal and business exchange. The transaction
demand for money is directly related to the level of income. It can
be calculated as follows:
Lr = kY
Lr = Transaction demand for
money k = ratio of earning which is
kept for transaction purposes
Y = earning
The precautionary motive
Individuals as well as businesses keep a portion of their income to
finance unanticipated expenditures. It depends on the size of income,
prevailing economic as well as political conditions and personal
characteristics of the individual etc.

The speculative motive

The speculative motive reflects people’s desire to hold cash in order to be
equipped to exploit any attractive investment opportunity requiring
cash. Investment gives two two type of income viz. interest and capital
gain.
If current rate of interest is higher than the critical rate of interest,
bond price is expected to increase. Person will invest in bond to
earn high interest and capital gain, so demand of money decrease.
If the current rate of interest is lower than the critical rate of interest,
bond price is expected to decrease. Person will hold cash to avoid
capital loss and low interest, so demand of money increase.
The inference from the above is that the speculative demand for money
and interest are inversely related.
Individual’s Speculative Demand for Money

Aggregate Speculative Demand for Money

(D) INVENTORY APPROACH TO TRANSACTION BALANCES (BY
BAUMOL) Baumol used business inventory approach to analyze the
behavior of individuals. Demand of money depends on two factors viz.
Interest rate and Transaction cost. If people hold money, there is loss of
interest. To earn interest, they have to invest money into bonds. But
conversion of money into bonds or bonds into money involves some
expenditure which is transaction cost. If rate of interest is high and
transaction cost is low, people co n ve rt maximum money into bond
and hold minimum cash which decrease demand of money. If rate of
interest is low and transaction cost is high, people hold maximum
amount in cash rather than bond which increase demand of money.
The individual will choose the number of times the transfer between
money
and bonds takes place in such a way that the net profits from bond
transactions (Interest – Transaction cost) are maximized. Therefore,
they hold an optimum combination of bonds and cash balance, i.e., an
amount that minimizes the opportunity cost and transfer cost.

(E) FRIEDMAN’S RESTATEMENT OF THE QUANTITY THEORY

Friedman states that demand for money is more general theory of demand
for capital assets. Demand for money is affected by the same factors as
demand for any other assets namely Income and relative return (risk).
There are four determinants of demand of money which is as follows:
(a) Wealth: Demand of money is a function of total wealth. People
demand
money to create wealth. They require money to earn money. Wealth
=
Permanent income/discount rate Permanent income is expected
future income, which can be earn from five assets
namely money, bonds, equity, physical assets, and human
capital (b) Price level: Price level rise, demand of money rise and
vice versa (c) Interest rate: Inversely related
(d) Inflation: Inversely
related

(F) DEMAND FOR MONEY AS BEHAVOIUR TOWARDS RISK (TOBIN)

A person can hold money or he can invest his money. There are two factors
which determine how much he should invest and what amount he should held
with him. First factor is return and second factor is risk.
If he invests his money in bond, he can earn interest but there is risk in
investment because there is price volatility of bond. It means return attached
with risk. If he held money with him, there is no return but there is no risk of
price volatility. It means he has to consider both factor at the time of
investment viz. return and risk.
If there is high return on investment compare to risk, the individual will
increase the proportion of wealth in bonds and decrease the holding of
money. If there is low return on investment compare to risk, the individual will
increase the proportion of wealth in cash and increase the demand of money.
 2. PAST YEAR QUSTIONS:
a. Nov. 20 Q7(c) – 3 Marks "Money performs many functions in an economy”.
Explain those functions briefly.
b. Nov. 19 Q11(b)(i) – 3 Marks Explain the neo-classical approach to demand
for money.
c. May 19 Q10(b)(i) – 2 Marks "Money has four functions: a medium, a
measure, a standard and a store." Elucidate.
d. May 19 Q11(a)(i) – 3 Marks Describe the determinants of demand for
money as identified by Milton Friedman in his restatement of Quantity Theory
of demand for money.
e. May 18 Q8(a)(i) – 3 Marks Explain the following modified equation of
exchange as given by Irving Fisher: MV +M'V'=PT
f. May 18 Q9(a)(i) – 3 Marks Explain why people hold money according to
Liquidity Preference Theory.
g. July21 Q9.a -3marks(i) Justify the following statements in the light of holding cash
balance
(1) For investment in interest bearing assets
(2) In the prevailing scenario, usually all transactions are made
through online or E-banking.

(3) Money is a unique store of value

h. July21Q10) a) i) 3marks

Fisher’s equation of exchange is: MV = PT. If velocity (V) = 25,

Price (P) 110.5 and volume of transaction (T) = 200 billion. Calculate:
Total money supply (m)
Effect on M when velocity (V) increases to 75
‘Velocity (V) when the volume of transactions increases to 325 billion.

I December21 Q 10 b i 3 marks
(i) Explain Friedman’sRestatement ofQuantityTheorywith reference
to demand for money ?

I December21 Q 11 c 2 marksWhat is speculative motive for holding cash

 3. REVISION TEST PAPER:

Nov 21 Q4i
(i) How does Friedman’s Restatement of the Quality theory is different from Keynes
speculative demand for money

May 21 Q6
(a) Explain the concept of Liquidity Trap.
(b) (i) Examine the relationship between purchasing power of money and
general price level.
(ii) Why do people demand money for precautionary motive?

May21 Q5(a)(i) Calculate velocity of money when-

Money Supply = 5000 billion Price =110
Volume of transaction = 200
(ii) What will be the outcome if volume of transaction increases to 225?
(b) Assess the role of Bank Rate as an instrument of monetary policy.

a. Nov. 20 Q6 Examine the influence of different variables on demand for money

according to Inventory Theoretic Approach?

b. May 20 Q6(a) Answer the following question using Keynesian framework of

demand for money. An investment consultant suggests holding of cash
instead of bonds. What could be the reason to encourage holding of money
balances? Explain

c. Nov 19 Q6(a) Explain the classical version of quantity theory of demand for
money.

d. May 19 Q6(a) Explain the function of money as a unit of account?

e. May 19 Q6(b) Examine the different variables on demand for money

according to inventory theoretic approach.

f. May 19 Q7(b) Which of the functions of money do the following items

satisfy?
(i) A credit card. (ii) A token of specified amount of money which can be used
for shopping.
Answer:
(i) A credit card is a medium of exchange
(ii) A token of specified amount of money which can be used for shopping
satisfies all 3 functions of money, which are store of value, unit of account,
and medium of exchange.

g. Nov 18 Q6(a) Critically examine the post Keynesian theories of demand for
money?

h. Nov 18 Q6(b) (i) In Keynesian analysis of speculative demand for money,

how will demand for money be affected if people feel that the level of interest
is very high? What is the rationale behind their choice? (ii) Do you think
money is a unique store of value?
i. May 18 Q6(a) Explain how speculative motive for holding cash is related to
market interest rate.
j. May 18 Q6(b) Describe the treatment of transactions demand for money as
per Baumol and Tobin’s model.
 UNIT 2 : MONEY SUPPLY

MONEY SUPPLY
Money supply means the stock of money. It refers to the stock of money
available to the public as a means of payment and store of value.
Public includes household, firms and institutions except Government and the
banking system. Demand deposit with bank is included in the meaning of
money supply.

RATIONALE OF MEASURING MONEY SUPPLY

1. Money supply is used for analysis. Analysis helps in understanding causes
of money growth.
2. Supply of money is used for price stability. Supply of money is
compared with standard and if there is deviation, it can be controlled.

SOURCES OF MONEY
SUPPLY

MEASUREMENT OF MONEY SUPPLY

The RBI has been publishing data on four alternative measures of money
supply denoted by M1, M2, M3 and M4 besides the reserve money, which are as
follows:
M1 = Currency notes and coins with the public
+ Demand deposit of banks
+ Other deposits of RBI
M2 = M1 + Saving deposits with post office saving bank
M3 = M1 + Net time deposits with the banking system
M4 = M3 + Total deposits with the post office saving (excluding NSC)

Note:
(1) The RBI regards these four measures of money stock as
representing different degrees of liquidity. It has specified them in the
descending order of liquidity, M1 being the most liquid and M4 the
least liquid of the four measures.
(2) Currency = Paper currency + coins.
(3) Demand deposits = Current A/c deposit + Saving A/c deposit (excluding
Interbank deposit)
(4) Other deposit of RBI = Demand deposit with RBI of quasi -government
 institutions, other financial institutions, Foreign central bank
and governments, International agencies sucas IMF and the World bank.
Following the recommendations of the Working Group on Money (1998),
the RBI has started publishing a set of four new monetary aggregates on
the basis of the balance sheet of the banking sector in conformity with
the norms of progressive liquidity. The new monetary aggregates are:

Reserve Money = Currency in circulation + Bankers’ deposits with the

RBI
+ Other deposits with the RBI = Net RBI credit to the Government + RBI
credit to the Commercial sector + RBI’s Claims on banks +
RBI’s net Foreign assets + Government’s Currency liabilities to the public
– RBI’s net non - monetary Liabilities
NM1 = Currency with the public + Demand deposits with the banking
system
+ ‘Other’ deposits with the RBI.
NM2 = NM1 + Short-term time deposits of residents (including and up to
contractual maturity of one year).
NM3 = NM2 + Long-term time deposits of residents + Call/Term funding
from financial institutions

The central bank also measures macroeconomic liquidity by formulating

various
‘liquidity’ aggregates in addition to the monetary aggregates. While the
instruments issued by the banking system are included in ‘money’, instruments,
those which are close substitutes of money but are issued by the non-banking
financial institutions are also included in liquidity aggregates.
L1 = NM3 + All deposits with the post office savings banks (excluding
National
Savings Certificates).
L2 = L1 +Term deposits with term lending institutions and refinancing
institutions
(FIs) + Term borrowing by FIs + Certificates of deposit issued by
FIs.
L3 = L2+ Public deposits of non-banking financial
companies

DETERMINANTS OF MONEY SUPPLY

High powered money or Reserve money Money multiplier approach

HIGH POWERED MONEY

It is the currency issued by central bank. It is the source of all money. It
is backed by supporting reserve and guarantee by government.
High powered money= Currency with the public + Banker’s deposit with the RBI
+ Other deposits
with the RBI

MONEY MULTIPLIER
It denotes by how much the money supply will change for a given change in
high- powered money. It indicates what multiple of the monetary base is
transformed into money supply. It is ratio that relates the changes in the
money supply to a
given change in monetary base. The money supply is defined as: M = m X
MB M = money supply, m = money multiplier
MB = monetary base or high powered money. Money multiplier: m = M/MB

MONEY MULTIPLIER APPROACH TO SUPPLY OF MONEY

As per money multiplier approach, supply of money is affected by three
factors: (a) the stock of high-powered money (H): Behavior of the Central
bank
(b) the ratio of reserves to deposits, e= {ER/D}: Behavior of commercial bank
(c) the ratio of currency to deposits, c ={C/D}: Behavior of the general public

(a) The stock of high powered money (The behavior of the central bank)
Central bank change money supply by two
ways: (1) Supply of high powered money
(2) Reserve
ratio

Supply of high powered money: If supply of high power money

increase, there is increase of money supply and vice versa. It means
supply of money and money multiplier is directly related to supply of
high powered money
Reserve Ratio: If Central bank increase reserve ratio, supply of
money decrease and vice versa. It means supply of money and money
supplier is inversely related to reserve ratio.

(b) The ratio of excess reserve to deposit (The behavior of

commercial bank)
Bank generally maintains extra reserve other than statutory ratio.
The purpose of maintenance of excess reserve is the expected risk of
deposit outflow.
Ratio of Excess reserve to deposit is called excess reserve ratio which
can be calculated as Follows: Excess reserve ratio = Excess
reserve/Deposit
Higher excess reserve ratio – Low loan – Low money supply Lowe
excess reserve ratio –
High loan – High money
supply
Excess reserve ratio depends on: (a) Interest rate (b) Expected deposit
outflow
If interest rate is high, excess reserve ratio is low and vice versa. It
means excess reserve ratio is inversely related to interest rate.
If there is high expectancy of deposit outflow, excess reserve ratio is
high and vice versa. It means excess reserve ratio is directly related to
expectancy of deposit outflow.

(c) The ratio of currency to deposit (The behavior of public)

The public either hold cash or deposit it into bank account. There is currency
ratio which represent holding of currency to deposit.
Higher the ratio means people hold high currency and deposit money falls. If
 deposit is low, bank can create only less credit money. Money multiplier falls and ultimately
supply of money decrease.
Lower the ratio means people hold less currency and deposit high amount in bank. If deposit is
high, bank can create high credit money. Money multiplier increase and ultimately supply of
money increase.
There is one more ratio which is Time deposit-demand deposit ratio. High ratio means high time
deposit, less reserve by bank, higher credit money, high credit multiplier and ultimately high
money supply. Low Time deposit-demand deposit ratio means low time deposit, high reserve by
bank, low credit money, low credit multiplier and ultimately low money supply.
It means, size of money multiplier is determined by required reserve ratio at the central bank, the
excess reserve ratio of the commercial bank, and the currency ratio of the public. Higher ratios
means lower the size of money multiplier and
low money supply. Lower ratio means higher the size of money multiplier, and high money
supply.

EFFECT OF GOVERNMENT EXPENDITURE ON MONEY SUPPLY

Due to increase in government expenditure, money supply increase. For expenditure,
government borrows from RBI and pay as expenditure to the public. Public deposit money in to
bank account which create further money (credit money).

1. PAST YEAR QUSTIONS:

a. Nov. 20 Q8(b)(ii) – 2 Marks
What is the impact of the following on credit multiplier and money supply, if Commercial
Banks keep:
(1) Less Reserve?
(2) Excess Reserve?
b. Nov. 20 Q9(b)(i) – 3 Marks
Compute M3 from the following data :
Component ₹ in Crores
Currency with the public 2,25,432.6
Demand Deposits with Banks 3,40,242.4
Time Deposits with Banks 2,80,736.8
Post office savings Deposits 446.7
(Excluding National Saving Certificates)
Other Deposits with RBI 392.7
(Including Government Deposits)
Post Office National Saving Certificates 83.7
Government Deposits with RBI· 102.5
c. Nov. 20 Q10(b)(ii) – 2 Marks
''The deposit multiplier and the money multiplier though closely related are not identical".
Explain briefly.
d. Nov. 19 Q7(c) – 2 Marks
Compute reserve money from the following data published by RBI:
(₹ in crores)
Net RBI credit to the government 8,51,651
RBI Credit to the commercial sector 2,62,115
RBI' s claim on Banks 4.10,315
Government's Currency liabilities to the public 1,85,060
RBI’s net foreign assets 72,133
RBI’s net non-monetary liabilities 68,032

e. Nov. 19 Q11(a)(ii) – 2 Marks

Compute credit multiplier if the Requited Reserve Ratio is 10% and 12.5% for every
₹ 1,00,000 deposited in the banking system. What will be the total credit money created by the
banking system in each case?

f. May 19 Q7(c) – 2 Marks

Compute M1 supply of money from the data given below:
Currency with public 2,13,279.8
Crores
Time deposits with bank 3,45,000.7
Crores
Demand deposits with bank 1,62,374.5
Crores
Post office savings deposit 382.9 Crores
Other deposits of RBI 765.1 Crores
 g. May 19 Q9(a)(ii) – 2 Marks
What will be the total credit created by the commercial banking
system for an initial deposit of ₹ 3000 at a Required Reserve Ratio 1.
(RRR) of 0.05 and 0.08 respectively? Also compute credit
multiplier.
h. Nov. 18 Q7(c) – 3 Marks
The RBI Published the following data as on 31st March, 2018. You are
required to compute M4:
1. (₹ in crores)
Currency with the public 1,12,206.6
Demand Deposits with Banks 1,93,300.4
Net Time Deposits with Banks 2,67,310.2
Other Deposits of RBI 614.8
Post Office Savings Deposits 277.5
Post Office National Savings Certificates (NSCs) 110.5
May 18 Q7(b) – 3 Marks
(b) What would be the impact of each of the following on credit multiplier
and money supply?
(i) If Commercial Banks keep 100 percent reserves.
(ii) If Commercial
Banks do not keep
reserves. (iii)If
Commercial Banks
keep excess reserve

July2019Q7B-
(b) In the context of India, measure money supply (In crores of)
(M3) as per guidelines published by Reserve 1

Bank of India.
 Currency notes and coins with the public 24,637.20

Demand deposits of Banks 2,01,589.60

Net time deposits with post office saving accounts 28,116.40

Other deposits with Reserve Bank 420.10

Saving deposits with post office saving banks 415.25

December 21 Q7 a 3marks

Particulars Amount
in (T)
Crore
Notes in Circulation 25,00,000
Circulation of Rupee Coins 26,000
Circulation of Small Coins 850

Cash on hand with Banks 95,000

Bankers’ Deposits with RBI 4,500

Other Deposits with RBI 180

Total Post office Deposits 12,000
Time Deposits with Banks 15,000

7. (a) The following information is given :

You are required to compute :
(i) Currency with the Public; and
(ii) Reserve Money.

December 21 Q8b ii 3 marks

(iii) Calculate Narrow Money (M I ) from the following information :

(T In Crore)

Currency with public 2,80,000

Demand Deposits with banks 4,00,000

Time Deposits with banks 3,40,000

Other deposits with RBI 5,80,000

Post Office Savings Deposits 90,000

December 21Q9c 3 marks

(c) Calculate Money Multiplier with the help of following information:

Reserve Ratio (r) = 10%

Currency = T 200 billion

Deposits = T 400 billion

Excess Reserve = 1 800 million

 2. REVISION TEST PAPER:

Nov 21 Q5 iv

(ii) What are the major component of Reserve Money?

NOV 21 Q4 ii
(ii) What are the operating procedures and instrument of monetary policy?

May 20 Q3 B
Discuss the importance of the distinction between private costs and social costs

a. Nov 20 Q7(a)
How is the behaviour of central bank in economy reflected? Explain.
b. Nov 20 Q7(b)
Distinguish between M1 and M2. Find out M1 when a country has the following monetary
asset information as of March 2020:
Components ₹ in million
Cash in hands of the public 300
Demand Deposits 400
Savings Type accounts 2000
Money Market Mutual Funds 1000
Traveller’s checks 50
Small Time Deposits 500
Large Time Deposits 450
Other Checkable Deposits 150
c. May 20 Q6(b)
Calculate liquidity aggregate L2 when the following information is given-
Particulars ₹in crore
Term deposits with term lending institutions 750
Term borrowing by refinancing institutions 450
All deposits with post office savings banks 1320
Term deposits with refinancing institutions 590
Certificate of deposits issued by FIs 290
Public deposits of non-banking financial companies 450
NM3 2650
National saving certificates 240
d. Nov 19 Q6(b)
Why empirical analysis of money supply is important?
e. Nov. 19 Q7(a)
Calculate the narrow money from the following information. Components in Million (₹)
Currency with the public 15473.2
Demand deposits of banks 6943.1
Saving deposits with post office saving banks 978.1
Other deposits of the RBI 501.2

f. Nov. 19 Q7(b)
What is high powered money? Calculate it from the following data: Components in Million (₹)
a. Net RBI Credit to the Government 41561.2
b. RBI credit to the Commercial sector 18459.3
c. RBI’s net non-monetary liabilities 24981.2
d. RBI’s claims on banks 31456.2
e. RBI’s Net foreign assets 10456.1
f. Government’s currency liabilities to the public 21417.1

g. May 19 Q7(a)
Define Reserve Money? Compute the Reserve Money from the following data Published by
RBI.
Components (In billions of ₹) As
on 7th July 2018
Currency in circulation 15428.40
Bankers Deposits with RBI 4596.18
Other Deposits with RBI 183.30

h. Nov 18 Q7(a)
Explain how each of the following may affect money multiplier and money supply?
(i) Fearing shortage of money in ATM’s, people decide to hoard money?
(ii) During festival season, people decide to withdraw money through ATMs very often
.
i. Nov 18 Q7(b)
Explain the money multiplier approach to money supply.
j. May 18 Q7(a)
Describe the different determinants of money supply in a country.
k. May 18 Q7(c)
Examine what would be the effect on money multiplier if banks hold excess
reserves?

UNIT 3: MONETARY POLICY

MONETARY POLICY - MEANING
Monetary policy refers to the use of monetary policy instruments which are at the
disposal of the central bank to regulate the availability, cost and use of money
and credit to:
• promote economic
growth,
• Price stability,
• Optimum levels of
output,
• Optimum
employment,
• Balance of payments
equilibrium,
• Stable currency
• Any other goal of government’s economic
policy.

OBJECTIVES OF MONETARY
POLICY
a) Stability in price or controlling
inflation b) Full employment
c) Regulate the issue of bank
notes
d) Operates currency and credit system to its
advantages e) Ensure adequate flow of credit to the
productive sector
f) Maintenance of a judicious balance between price stability and
economic growth.
g) Debt management
h) Rapid economic
growth
i) Moderate long term interest
rate
j) External balance of payments
equilibrium

MONETARY TRANSMISSION MECHANISM

The process or channels through which the change of monetary policy affects
the level of product and prices is known as ‘monetary transmission mechanism’.
There are mainly four different mechanisms through which monetary policy
influences the price level and the national income. These are:
(a) the interest rate
channel,
(b) the exchange rate
channel, (c) the quantum
channel
(d) the asset price
channel

Interest rate channel:

Contractionary policy: Increase in interest rate – Low borrowing – Cut
investment
– High borrowing reduced demand – Finally fall in output and
employment. Expansionary policy: Opposite effect.
(a) Exchange rate channel:
Contractionary policy: Appreciation of the domestic currency ‐
Domestically
produced goods more expensive - Exports fall and import increase – Fall in
output
and employment.
Expansionary policy: Opposite
effect
(b) Quantum channel or bank lending channel:
Contractionary policy: Decrease Bank lending through decrease in
supply of money – Cut investment – Fall in output and employment
Expansionary policy – Opposite effect.

(c) Assets price channel or balance sheet channel:

Contractionary policy: Increase bank interest rate – High
interest payment – High cost of capital – Decrease in value of
business – Decrease price of equity
share – Decrease in demand due to high interest payment - Fall in output
and employment
Expansionary policy: Opposite effect

OPERATING PROCEDURE AND INSTRUMENTS

Operating procedure means implementation of monetary policy by RBI. There
are three steps:
(1) Choose operating target: Choose variable which we want to influence directly
(2) Choose intermediate target: Variable which we hope to influence
through operating target
(3) Choose policy instrument: Select tool to be used to accomplish our target

CASH RESERVE RATIO

Cash Reserve Ratio refers to the fraction of the total net demand and time
liabilities of a scheduled commercial bank which it should maintain as cash
deposit with the Reserve Bank. Non- Bank Financial Institutions are outside
the purview of this reserve requirement. No interest on reserve but penalty on
non-maintenance. During inflation:
High CRR → Reduced lending → Low liquidity → Fall in output and demand
→ reduced price
During slowdown in the economy:
Low CRR → Increased lending → Increase liquidity → Increase output and
demand.

STATUTORY LIQUIDITY RATIO

It refers to fraction of total demand and time liabilities of a commercial bank
are required to maintain in one of the following forms:
1. Cash
2. Gold
3. Investments in un-encumbered Instruments that include:
 a) Treasury-bills of the Government of India.
b) Dated securities including those issued by the Govt. of India from
time to time und er the market borrowings programme and the
Market Stabilization Scheme (MSS).
c) State Development Loans (SDLs) issued by State Governments
under their market borrowings programme.
d) Other instruments as notified by the RBI.

Failure to maintain it is liable to penalty. Contraction

policy:
Increase S L R → Reduced lending → Reduced liquidity → Low
investment
→ Low Out and demand → Reduced
price

Expansion policy:
Decrease SLR → Increase lending → Increase liquidity → increase
investment
→ High output
employment.

LIQUIDITY ADJUSTMENT FACILITY

This facility provided by RBI to assist commercial banks to adjust their day-to-day
mismatch liquidity. RBI provides financial accommodation to the commercial bank
through Repo and Reverse Repo under Liquidity adjustment facility.
Repurchase option (REPO): When commercial bank sell securities to RBI with an
agreement to repurchase the securities on agreed future date is called Repo. It is
basically borrowing by commercial bank from RBI on security of govt. securities or
any other specified securities. The interest rate charged by RBI on such transaction
is called REPO rate. It increases liquidity in the system.
Reverse repo: When commercial bank purchase securities from RBI with an
agreement to resell the securities on agreed future date is called reverse repo. It is
basically borrowing by RBI from banks on security of govt. securities or any other
specified securities. It decreases liquidity in the system. The interest rate paid by
RBI for such transaction is called reverse repo rate.

MARGINAL STANDING FACILITY

If a commercial bank require fund over and above LAF, it can borrow by reducing
statutory liquidity ratio up to a limit in case of emergency. It is called Marginal
standing facility. There is high rate of interest which include penal rate above repo
rate.
Main aim of MSF is reducing volatility in the overnight lending rates and to enable
smooth monetary transmission. The MSF would be the last resort for banks once
they exhaust all borrowing options including the liquidity adjustment facility on which
the rates are lower compared to the MSF. On MSF, high rate; on REPO, rate at the
middle and on Reverse repo at lower rate.

MARKET STABILISATION SCHEME

If there is large inflow of foreign capital, Govt. absorb excess liquidity by this
scheme. In this scheme, Govt. borrow fund from RBI which is additional borrowing
to its normal borrowing requirement and issues treasury bills securities. It is also
called sterilization process.
OPEN MARKET OPERATIONS
In case of high inflation: Sale govt. Securities in market – Decrease liquidity in
market – Demand decrease- Investment decrease – Inflation reduce In case of
recession: Buy Govt. Securities – Liquidity increase – Demand increase –
Investment increase – Output and employment increase

BANK RATE
It is standard rate at which the RBI is prepared to buy or re-discount bills of
exchange or other commercial paper eligible for purchase under the Act. The bank
rate once used to be the policy rate in India. Discounting/rediscounting of bills of
exchange by the Reserve Bank has been discontinued on introduction of Liquidity
Adjustment Facility (LAF). Now, bank rate is used only for calculating penalty on
default in the maintenance of Cash Reserve Ratio (CRR) and the Statutory Liquidity
Ratio (SLR).

ORGANISATIONAL ST RUCT URE FOR MONETARY POLICY

DECISIONS (1) THE MONETARY POLICY FRAMEWORK
AGREEMENT
There is agreement between RBI and Government of India to fix target
rate and maximum and minimum tolerable inflation rate which is also
known as inflation targeting. At present, inflation targeting is the primary
objectives of monetary policy.
Inflation target will be set by Government of India in consultation with RBI once
in every five year. Present inflation target rate is 4% and upper tolerance rate
is 6% and lower tolerance rate is 2%. The RBI is mandated to publish
monetary policy report every six months.
The following factors are notified by the central government as constituting a
failure to achieve the inflation target:
a) The average inflation is more than the upper tolerance level of
the inflation target for any three consecutive quarters; or
b) The average inflation is less than the lower tolerance level for any
three consecutive quarters.

(2) THE MONETARY POLICY COMMITTEE Member:

Total six members
(1) RBI Governor:
Chairperson
(2) RBI Deputy Governor: In charge of monetary
policy
(3) One official nominated by RBI
board
(4) Three central government nominee (persons of ability, integrity and
standing, having knowledge and experience in the field of
Economics or banking or finance or monetary policy)

Function:
Determine policy rate to achieve the inflation target and meets daily to review
the liquidity conditions so as to ensure that the operating target of monetary
policy (weighted average lending rate) is kept close to the policy repo rate.

Operation
Fixing of the benchmark policy interest rate (repo rate) is through debate
and majority vote by this panel of experts.
The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC
in formulating the monetary policy.
The Financial Markets Operations Department (FMOD) operationalises the
monetary policy, mainly through day -to-day liquidity management operations.

Objective
The system is intended to incorporate diversity of views, specialized
experience, independence of opinion, representativeness, and accountability

MONEY MARKET AMENDMENTS

Bi-monthly Monetary Policy Statement of 2018-19 by
RBI (As on September 2020)

Monetary Policy Instrument Rate

CRR 3%
SLR 18%
Reverse repo rate 3.35%
Repo rate 4%
MSF / Bank rate 4.25%

LIST OF FORMULAE
1) Net Demand and Time Liabilities = Demand and Time Liabilities (with
the public or other bank) -Deposits in the form of assets held by the other
bank.
2) Money Supply = Currency + Deposits
3) Monetary Base = Currency + Reserves
C urren c y in t he hands of t he
4) Currency ratio (or) Currency deposit ratio (c) = public
Demand deposits
Reserve
5) Reserve ratio (r) = Demand deposits
1
6) Money multiplier (or) Credit multiplier (or) Deposit multiplier =Reserve requirement
Mo n ey Supply (M ) c +1
7) Money multiplier (Mm)=Monetary Base (H) =
c+r

M=Mm x H
c+1
𝑀=( ) ×H
c+r
8) From April 1977, following the recommendations of the second
Working Group on Money Supply (SWG), the RBI published data on four
alternative measures of money supply:
M1= Currency notes and coins with the people demand deposits of banks
(Current and Saving deposit accounts) + other deposits of the RBI
M2 = M1 + savings deposits with post office saving banks
M3= M1 + net time deposits with the banking system
M4 = M3 + total deposits with the post office Savings Organization (excluding
National Savings M4 = M3 + total deposits with the Certificates).
9) Following the recommendations of the Working Group on Money (1998),
the RBI published a set of four new monetary aggregates as:
Reserve Money = Currency in circulation + Bankers' deposits with
the RBI + Other deposits with the RBI,
NM1 = Currency with the public + Demand deposits with the banking
system + 'Other' deposits with the RBI,
NM2 = NM1 +Short-term time deposits of residents (including and
up to contractual maturity of one year),
NM3 = NM2 + Long-term time deposits of residents+ Call/Term
funding from financial institutions

10) The Liquidity aggregates are

L1 = NM3 + All deposits with the post office savings banks (excluding
National
Savings Certificates).
L2 = L1 +Term deposits with term lending institutions and refinancing
institutions (Fis) + Term borrowing by Fis+ Certificates of deposit issued
by Fis.
L3 = L2+ Public deposits of non-banking financial
companies

1) Concept of Demand for Money:

a) Irving Fisher (Classical Approach: The Quantity Theory of Money): MV
+ M'V' = PT
d
b) Cambridge Approach (Neo Classical Approach): M = kPY
c) Keynes (Liquidity Preference Theory): Lr = kY

ILLUST RAT
IONS

1) What would be the impact of each of the following on credit multiplier

and money supply?
i. If commercial Banks keep 100 percent reserves.
ii. If commercial Banks do not keep reserves. If commercial Banks
keep excess reserves.

2) In a period, Reserve Money is 36,000 and Narrow Money M1 is `

42,000. If the Total of Currency in Circulation + Other Deposits of RBI is
15,000, Compute (a) Banker's Deposits with RBI, (b) Net Demand
Deposits of banks. (assume amounts in ` Crores)
(ANS.: (a) ` 21,000 CRORES; (b) ` 27,000 CRORES)
3) Compute Reserve Money from the following data published by
RBI Components (In billions of `) As on 7th July 2017.
Currency in Circulation 15,428.40
Bankers' Deposits with RBI 4,596.18
'Other' Deposits with RBI 183.30
(ANS.: ` 20,207.88)

4)
Components (In billions of `) as on 31 March,
Currency with the Public 12,637.1
Demand Deposits with Banks 14,106.3
Time Deposits with Banks 1,01,489.5
'Other' Deposits with Reserve Bank 210.9

5) What will be the total credit created by the commercial banking system for
an initial deposit of `1000/- for required reserve ratio 0.02 ,0.05 and 0.10
percent respectively? Compute credit multiplier.
(MTP MAR 18) (ANS.: 50,000; 20,000; 10,000)

6) In the economy, the following statistics describe the money supply:

Currency=$
1,000 billion, Reserves=$ 125 billion Deposits=$ 4,000 billion
Calculate the amount of the monetary base; Quantity of the money supply;
ratio of reserves to deposits; ratio of currency to deposits, money
multiplier. (ANS.: $1,125 BILLION; $5,000 BILLION; 0.0313; 0.25;
4.4444)
2. PAST YEAR QUSTIONS:
a. Nov. 20 Q11(a)(i) – 3 Marks What is the meant by 'Statutory Liquidity
Ratio’? ·In which forms this ratio is maintained?
b. Nov. 19 Q8(a)(ii) – 2 Marks Explain the open market operations
conducted by RBI.
c. Nov. 19 Q10(b)(ii) – 2 Marks Explain 'Reverse Repo Rate'.
d. May 19 Q8(b)(ii) – 2 Marks Why is the central bank referred to as a
"banker's bank" ?
e. Nov. 18 Q8(b)(ii) – 3 Marks Explain the role of Monetary Policy
Committee (MPC) in India.
f. Nov. 18 Q11(a)(i) – 3 Marks Explain the different mechanism of
monetary policy which influences the price-level and national income.
g. Nov. 18 Q11(a)(ii) – 2 Marks Explain the Monetary Policy Framework
Agreement.
h. May 18 Q11(b)(ii) – 3 Marks How do changes in Cash Reserve Ratio
(CRR) impact the economy? –
I July21 Q10 b ii-2marks Describe the differences between Liquidity Adjustment
Facility(LAF) and Marginal Standing Facility (MSF).
3. REVISION TEST PAPER:
Nov 21 iiiHow does money supply impacted inflation in the economy?

a. May 20 Q5 How does the monetary policy influence the price level and
the national income?
b. May 20 Q10(b) Explain the role of Liquidity Adjustment Facility (LAF).
c. May 19 Q7(c) What role does Market Stabilization Scheme (MSS) play
in our economy?
d. Nov 18 Q7(c) Explain the function of SLR? What are the eligible
securities of SLR?
e. Nov 18 Q8(b) What is meant by ‘monetary policy instruments’?
f. May 18 Q7(b) What role does Market Stabilization Scheme (MSS) play
in our economy?
g. May 18 Q7(d) Write a note on Cash Reserve Ratio (CRR). Explain the
operation of CRR.