Session 8

Macro Economics
Prof Chandrika Raghavendra
 Topics to be covered

• Monetary policy and central bank

– Money Supply
– Monetary Policy Instruments
– Money Multiplier effect
Mr Shaktikanta Das
Governor, RBI
 Power to ‘Controls the Money Supply’
Power to ‘Create Money’ Execute these powers
through
Power to ‘Trade Trillions in Govt. Bonds’
Power to act as ‘Lender of Last Resort’ Monetary Policy

RBI has Powers

(NOT SUPER POWERS!)
Monetary policies describe the RBI’s actions to control the supply of
money and influence the economy, it can only affect in short term!

Despite of its powers, RBI also has its own challenges

(limitations and weaknesses)
Money, is anything, which is Widely Accepted as Means of Payments

Money is anything, that is either in liquid form or those

which can be easily converted into cash without
losing/with little lose in its value
What is Money Supply?

The money supply is the total stock of money that is in

circulation in an economy on any specific day

This includes all the notes, coins and demand deposits

held by the public on such a day

Money supply is a stock variable because it is measured

at a point of time
 Savings Deposits of
Currencies held Post Office Savings
by public (CC)

M2 = M1 + Savings
Deposits of Post
Office Savings

Reserve money (M1) is also

called central bank money,
monetary base, base
money, or high-powered
M1 = CC + DD + Other Deposits +
money

M2 = Narrow money

Current and Savings account

deposits (DD); all other deposits of
banks with RBI (Other)
 Time Deposits of banks Post office Savings

Currencies held
by public (CC)

M3 = Broad
Money

M1 = CC + DD + Other Deposits
+ +

M3 = M1 + time M4 = M3 + Post
deposits of office savings
banks

Current and Savings account

deposits (DD); all other deposits of
banks with RBI (Other)
 M1 M2 M3 M4

When the Reserve Bank of India (RBI) takes

monetary policy actions, it primarily influences the
money supply known as M3, which is the broadest
measure of money supply
 Monetary Policy In India
• Monetary Policy Committee suggested to maintain inflation at 4% (with +/-2%) between 2021
and 2026
• RBI uses certain tools to control the inflation- Monetary Policy Tools
• There are two types of tools
– Quantitative Tools or General Tools or Indirect Tools
– Qualitative Tools or Selective Tools or Direct Tools
Monetary Policy Instruments
So what fraction of your deposit do banks keep in reserve?
 Fractional Reserve Systems

? Under the fractional reserve banking system, the central bank declares a minimum
ratio of deposits to the total deposits with a bank that all the banks must
𝟏𝟎𝟎 maintain.

CRR SLR

Depends upon ‘how much

4.5% 18%
money must be supplied’

Note: CRR lost its relevance after BASEL III norms

Read: https://www.thehindubusinessline.com/opinion/cash-reserve-ratio-has-lost-its-relevance/article64594370.ece
 Loans
100 - 22.5 = 77.5%
Cash Reserve Ratio

Cash & Equivalents

No Interest
Low CRR = Happy
Banks
Fixed, SB and Current A/c

NDTL (Net Demand and 4.5 + 18 = 22.5%

Time Liabilities)
= Deposits - Withdrawals

Statutory Liquidity Ratio

Liquid Assets - Cash &

Suppose, Equivalents, Gold or
NDTL = 100 Cr. Govt. Securities
Interest/revenue

SLR AND CRR

• CRR was mandated under RBI Act of 1934; SLR was mandated under Banking Regulation Act
1949
• Every Alternative FRIDAYs Banks have to submit a report on their NDTL to RBI
• RBI has its own centralized tracking system- e-Kuber, where RBI can access to any NDTL
information at any point of time.
– However, Banks must submit a NDTL report on every alternative Friday.

A NDTL Report on Every Alternative FRIDAYs

 Open Market Operations
Govt. Security

To control AD and inflation, RBI sells Govt.

Securities

Money

Money

To increase AD and inflation, RBI buys Govt.

Securities

Govt. Security
 Which is most Liquid?

More
$$

Demands More Results in

Money supply control/Price Stability
RBI’s action to control money supply or bring price
stability is “LIQUIDITY ADJUSTMENT FACILITY”

Controls
 Liquidity Adjustment Facility

• Repo
– Long Term Repo Operations
– Targeted Long Term Repo Operations
– Special Long Term Repo Operations
• Reverse Repo
• Standing Deposit Facility
• Marginal Standing Facility
 REPO rate – RE-Purchase Obligation

Rate at which banks borrow from RBI on a very short term basis

Banks have to put govt. securities as collateral and have an option to buy those securities back at the end
of prescribed period, generally overnight

Banks can not use securities from SLR as collateral

 If RBI Costlier for Interest rate Costlier for you Demand for Price of car
raises repo banks to rises and I to borrow car goes will come
borrow money to buy car down down

Decrease in Decrease in
money supply Inflation

If RBI Cheaper for Interest rate Cheaper for you Demand for Price of car
reduces repo banks to falls and I to borrow car goes up will go up
borrow money to buy car

Increase in Increase in
money supply Inflation
 Some Special REPO facilities Windows from 2020 Due to
Covid’19
Long Term Repo Operations
 When REPO transaction takes place for long term (1-3 years), it is called Long Term Repo Operations
 Was introduced in Feb 2020
 Up to Rs 1,00,000 crore of limit; with minimum of Rs 1 crore; transaction happens through e-Kuber platform

Targeted Long Term Repo Operations

 When REPO transaction takes place for long term (1-3 years), and at least x% of such funds are apportioned in
targeted firms to lend, it is called Targeted Long Term Repo Operations
 At least 50 percent of the total funds availed shall be apportioned as given below:
• 10 per cent in securities/instruments issued by Micro Finance Institutions (MFIs);
• 15 per cent in securities/instruments issued by NBFCs with asset size of ₹ 500 crore and below; and
• 25 per cent in securities/instruments issued by NBFCs with assets size between ₹ 500 crores and ₹ 5,000 crores.

Special Targeted Long Term Repo Operations

 When REPO transaction with small finance banks takes place for long term (1-3 years), and lending is done only to
MSME and Unorganized Sector it is called Special Targeted Long Term Repo Operations
REVERSE REPO
Some Special windows under Liquidity Adjustment Facility

Standing Deposit Facility

 Banks can park their excess money with RBI without
any collateral to earn short term return
 Similar to Reverse Repo, except the collateral

Marginal standing facility (MSF)

 Is a window for banks to borrow from the RBI in an emergency situation when inter-bank liquidity dries up
completely for short term and must provide collateral
 The MSF rate is a percentage point above the repo rate
 Under MSF, banks can borrow funds up to one percentage of their NDTL
Bank Rate/Penalty Rate

Money

To increase AD and inflation, RBI lends money to

banks for a long term at higher rate of interest

No Collateral required
 Effect on Money Supply
The banking system has a big effect on supply of money

DEPOSIT
Rs 900
Rs 1000 LOAN

Rs 100 RESERVE
 Effect on Money Supply
The banking system has a big effect on supply of money

TOTAL DEPOSIT
Rs
1900
DEPOSIT
Rs 900
Rs 1000 LOAN

Rs 100 RESERVE
 Effect on Money Supply
The banking system has a big effect on supply of money

Increased
M1

LOAN
Rs 900

TOTAL DEPOSIT
Rs
1900
DEPOSIT
Rs 1000

Rs 100 RESERVE
 Effect on Money Supply
The banking system has a big effect on supply of money

LOAN

Rs 810 Increased M1

More loans  More deposits 

More loans  More Deposits  ….

TOTAL DEPOSIT
LOAN
Rs 900 Rs
2710

Rs This Process continues

1900 and Money Supply gets
DEPOSIT
created
Rs 1000 Rs 90 RESERVE
Rs 100 RESERVE
 MONEY
MULTIPLIER! So how much money
do we ultimately end
up with?
 The money multiplier tells us how many dollars'
worth of deposits are created with each
additional dollar of reserves

So, if the reserve ratio is 10%

𝟏
𝑴𝒐𝒏𝒆𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 =
𝟎. 𝟏

𝑴𝒐𝒏𝒆𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 = 𝟏𝟎

It's just 1 divided by the

Reserve Ratio Which means, $1 in new reserves will
ultimately lead to $10 of additional money,
as measured by M1
 𝟏
𝑴𝒐𝒏𝒆𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 = = 𝟏𝟐. 𝟓
𝟎. 𝟎𝟖
Increase the Money Supply
𝟏
𝑴𝒐𝒏𝒆𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 = = 𝟐𝟎
𝟎. 𝟎𝟓

𝟏
𝑴𝒐𝒏𝒆𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 = = 𝟏𝟎
𝟎. 𝟏

𝟏
𝑴𝒐𝒏𝒆𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 = = 𝟖. 𝟑
𝟎. 𝟏𝟐
RBI will have a lot of Decrease the Money Supply
leverage to move M1 and
M2 with a small change in 𝟏
reserves 𝑴𝒐𝒏𝒆𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 = = 𝟔. 𝟕
𝟎. 𝟏𝟓
Alternative formula to calculate Money Multiplier

𝟏
𝑴𝒐𝒏𝒆𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 =
𝑳𝑹𝑹

Where, LRR (legal reserve ratios) = SLR + CRR

LRR = 18% + 4.5%
= 22.5%

𝟏
𝑴𝒐𝒏𝒆𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 = = 4.44
𝟎.𝟐𝟐𝟓

Which means, ₹ 1 in new reserves will

ultimately lead to ₹ 4.4 of additional money
supplied
Question!

Will it create more Reserves?

No, it will not create more

reserves, and hence no
multiplier effect
 Money Multiplier during Recession

Banks prefer not to lend and hence

accumulates reserves

Causing –
1. Money multiplier falls
2. Leading to lesser money supply
3. More efforts of RBI to infuse money

Depositors prefer to hold their

cash instead of depositing
 Learning Outcomes

• Monetary policy and central bank

– Money Supply M1, M2, M3 and M4
– Monetary Policy Instruments  Fractional Reserve Rations (CRR & SLR), Open Market
Operations, Bank Rate, Liquidity Adjustment Facility (REPO, Reverse REPO, Standard Deposit
Facility, Marginal Standard Facility and other special facilities)
– Money Multiplier effect