Ch. 29 - The Monetary System

Chpater 29
The Monetary System
EPP110 MACROECONOMICS
MONSOON 2020-21
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Money: Definition
Money is the stock of

assets that can be used to
make transactions.
Money: Functions
1. Medium of Exchange: we use it to buy things (goods and services).

-It is readily acceptable as payment.
2. Store of value: transfers purchasing power from the present to the
future
3. Unit of account: the common unit through which everyone
measures prices and values
4. Standared of deferred Payments: It is a unit in terms of which
debts and future transactions can be settled.
Money: Types
1. fiat money
 No intrinsic value or its intrinsic value is less than the face value.
 example: the paper currency we use
2. Commodity money
 Has intrinsic value
 examples:
gold coins,
cigarettes in concentration camps
Forms of Money in a Modern Economy
1. Token coin : face value>intrinsic value e.g. nickel, copper and bronze coins
(limited legal tender)
2. Standard coin/full-bodied coin : face value=intrinsic value e.g. gold and silver
coins
Coins upto 50 paise are called 'small coins' and coins of Rupee one and above are
called 'Rupee Coins'.
As per the Coinage Act, 1906. Coins can be issued up to the denomination of Rs.1000
 Paper money: It is used widely in many countries.
 Plastic Money: First introduced in 1950 in U.S.A. However, they gained ground in
1970.
THE RESERVE BANK OF INDIA
The Reserve Bank of India (RBI) serves as the nation’s central bank.
 It was established on 1st April, 1935.
 It is designed to oversee the banking system.
 It regulates the quantity of money in the economy.
THE RESERVE BANK OF INDIA
Reserve Bank issued banknotes in January 1938 when the first Five
Rupee banknote was issued bearing the portrait of George VI.
This was followed by Rs. 10 in February, Rs. 100 in March and Rs. 1,000
and Rs. 10,000 in June 1938.
The George VI series continued till 1947 and thereafter as a frozen
series till 1950 when post independence banknotes were issued, with
the Ashoka Pillar watermark.
British Indian One, Five and Ten Rupee Note
The Organization Structure of the Reserve Bank of India:
Governor (1)
Deputy Governors (4)
Executive Directors
Principal Chief General Managers
Chief General Managers
General Managers
Deputy General Managers
Assistant General Managers

The governor is Reserve Bank’s Chief executive.

The governor supervises and directs the affaires and businesses of
Reserve bank.
The management team also includes Deputy Governors and executive
Directors.
The RBI has offices at 31 locations.
RBI’s Clean note policy
No stapling, writing, excessive folding

Timely removal of soiled notes
Exchange facilities for torn, mutilated or defective notes: at currency
chest of commercial banks and in Reserve Bank issue offices
The objectives of the Reserve Bank
To regulate the issue of Bank notes and the keeping of reserves, with a
view to securing monetary stability in India.
Functions Reserve Bank of India
Three Primary Functions of the RBI

 Regulates banks to ensure they follow laws intended to promote safe and sound
banking practices.
 Acts as a banker’s bank, making loans to banks and as a lender of last resort.
 RBI provides liquidity to banks unable to raise short-term liquid resources from the inter-
bank market.
 Provides short-term loans and advances to banks when necessary to facilitate lending
 Conducts monetary policy by setting the interest rates.
Banker to government
Government needs a banker to carry out its financial transactions in an

efficient and effective manner including the raising of resources from
the public.
Manages the government’s banking transactions
Maintains the accounts
Receives money into and makes payment out of this accounts
Facilitates the transfer of government’s funds
Manager of Foreign Exchange
Regulating transactions related to external sector and facilitating

development of foreign exchange market.
Ensuring smooth conduct and orderly conditions in the domestic
foreign exchange market
Managing foreign currency assets and gold reserves of the country
Money supply in the Economy
Money Supply is the quantity/amount of money which is in circulation

an economy at any given time.
Money supply is a stock as well as flow concept.
Different ways of measuring the money stock in the economy:
 M1
 M2
 M3
 M4
Definition of money – Old Classification
• Currency
M1 • Demand deposits
• Other deposits
• M1
M2 • Post office savings deposits
M • M1
• Term deposits with
3 banks
M • M3
• Total post office deposits
4
Definition of money - Revised
Narrow
Money
NM • Currency
• Demand deposits M1 + Short
1 • Other deposits term deposits of
residents
• NM1
NM • Time liability portion of savings deposits with
banks
2 • Certificates of Deposits by banks
• Term deposits maturing in one year Broad
money
• NM2
NM • Term/time deposits over one year
3 maturity
• Call/term borrowings of banks
Narrow Money and Broad Money
Narrow Money (M1) and Broad Money (M3) in Rupees crores

18000000
16000000
14000000
12000000
10000000
8000000
6000000
4000000
2000000
0
1990- 1991- 1992- 1993- 1994- 1995- 1996- 1997- 1998- 1999- 2000- 2001- 2002- 2003- 2004- 2005- 2006- 2007- 2008- 2009- 2010- 2011- 2012- 2013- 2014- 2015- 2016- 2017- 2018- 2019-
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20
Narrow Money Broad Money
Liquid Resources
• New M3
L1 • Post Office Savings Bank
Deposits (excluding NSCs)
• L1
• Term deposits with term lending
L2 institutions
• Term borrowings of Financial Institutions
• Certificates of Deposit issued by the FIs
• L2
L3 • Public deposits of NBFCs
Factors affecting/Determinants of Money Supply
 Extent of monetization
 The cash reserve ratio
 Bank credit to the government
 Bank credit to private sector
 Balance of payment situation
 Velocity of circulation of money
Two Measures of the Money Stock for the U.S. Economy
The two most widely followed measures of the money stock are M1 and M2. This
figure shows the size of each measure in 2009.
The Federal Reserve System
Federal Reserve (Fed)

 The central bank of the United States
Central bank
 Institution designed to
 Oversee the banking system
 Regulate the quantity of money in the economy
The Federal Reserve
 Created in 1913
 After a series of bank failures in 1907
 Purpose: to ensure the health of the nation’s banking system
The Fed’s Organization
Board of governors
 7 members, 14-year terms
 Appointed by the president & confirmed by the Senate
 The chairman
 Directs the Fed staff
 Presides over board meetings
 Testifies regularly about Fed policy in front of congressional committees.
 Appointed by the president (4-year term)
The Federal Reserve System
 Federal Reserve Board in Washington, D.C.
 12 regional Federal Reserve Banks
 Major cities around the country
 The presidents - chosen by each bank’s board of directors
The Fed’s jobs

 Regulate banks & ensure the health of the banking system
 Regional Federal Reserve Banks
 Monitors each bank’s financial condition
 Facilitates bank transactions - clearing checks
 Acts as a bank’s bank
 The Fed – lender of last resort
The Fed’s jobs

 Control the money supply
 Quantity of money available in the economy
 Monetary policy
 By Federal Open Market Committee (FOMC)
Money supply
 Quantity of money available in economy
Monetary policy
 Setting of the money supply
Federal Open Market Committee(FOMC)
Fed’s primary tool: open-market operation

 Purchase & sale of U.S. government bonds
FOMC - increase the money supply
 The Fed: open-market purchase
FOMC - decrease the money supply
 The Fed: open-market sale
Banks And The Money Supply
Reserves are deposits that banks have received but have not
loaned out.
In a fractional-reserve banking system, banks hold a
fraction of the money deposited as reserves and lend out the
rest.
Reserve Ratio
 The reserve ratio is the fraction of deposits that banks hold
as reserves.
 When a bank makes a loan from its reserves, the money supply
increases.
 The money supply is affected by the amount deposited in banks and
the amount that banks loan.
 Deposits into a bank are recorded as both assets and liabilities.
 Loans become an asset to the bank while deposits become
liability.
The simple case of 100% reserve banking

 All deposits are held as reserves
 Banks do not influence the supply of money
Fractional-reserve banking
 Banks hold only a fraction of deposits as reserves
Reserve ratio
 Fraction of deposits that banks hold as reserves
Reserve requirement
 Minimum amount of reserves that banks must hold; set by the Central Bank
Excess reserve
 Banks may hold reserves above the legal minimum
Example: First National Bank
 Reserve ratio 10%
The Money Multiplier
Total Money Supply: 100+90+81=$271
The Credit Multiplier
The money/credit multiplier

 Original deposit = $100.00
 First National lending = $ 90.00 [= .9 × $100.00]
 Second National lending = $ 81.00 [= .9 × $90.00]
 Third National lending = $ 72.90 [= .9 × $81.00]
…
 Total money supply = S = a/(1-r) where 0< r<1 = 100/(1-

∞
0.9)= $1,000.00
The Money Multiplier
The money multiplier

 Amount of money the banking system generates with each dollar of reserves
 Reciprocal of the reserve ratio = 1/R
 With a reserve requirement, R = 20% or 1/5, the multiplier is 5.
The higher the reserve ratio

 The smaller the money multiplier
Financial Crisis of 2008–2009
Bank capital
 Resources a bank’s owners have put into the institution
 Used to generate profit
Leverage
 Use of borrowed money to supplement existing funds for purposes of investment
Leverage ratio
 Ratio of assets to bank capital
Capital requirement
 Government regulation specifying a minimum amount of bank capital
If bank’s assets – rise in value by 5%

 Because some of the securities the bank was holding rose in price
 $1,000 of assets would now be worth $1,050
 Bank capital rises from $50 to $100
 So, for a leverage rate of 20
 A 5% increase in the value of assets
 Increases the owners’ equity by 100%
If bank’s assets – reduced in value by 5%

 Because some people who borrowed from the bank default on their loans
 $1,000 of assets would be worth $950
 Value of the owners’ equity falls to zero
 So, for a leverage ratio of 20
 A 5% fall in the value of the bank assets
 Leads to a 100% fall in bank capital
Banks in 2008 and 2009

 Shortage of capital
 After they had incurred losses on some of their assets
 Mortgage loans
 Securities backed by mortgage loans
 Reduce lending (credit crunch)

 Contributed to a severe downturn in economic activity
U.S. Treasury and the Fed

 Put many billions of dollars of public funds into the banking system
 To increase the amount of bank capital
 It temporarily made the U.S. taxpayer a part owner of many banks
 Goal: to recapitalize the banking system
 Bank lending could return to a more normal level
 Occurred by late 2009
Limitations of Money Multiplier
Amount of Deposit
The most important factor which decides credit creation is the amount
of deposits made by the depositors. Higher is the amount of deposits,
greater is the supply of credit and vice versa.
Cash Reserve Ratio (CRR)

There exists an indirect relationship between Credit Creation and Cash
Reserve Ratio (CRR).
Higher is the Cash Reserve Ratio (CRR) more will be the reserves to be
maintained and less credit will be created by banks.
The CRR is fixed by the RBI in India. It ranges between 3% to 15%.
Banking Habits of People
If the banking habits of the people are well-developed, then all their
transactions would be through banks, and this will lead to expansion of
credit and vice-versa.
Supply of Securities
Loans are sanctioned on the basis of the securities provided to the banks. If
securities are available then the credit creation will be more and vice-versa.
Willingness of people to borrow

Commercial banks may have enough money to lend. Customers should
be willing to borrow from the banks to facilitate credit creation.
Monetary Policy of Central Bank

While credit is created by commercial banks, it is controlled by the
Central Bank.
Credit control is one important function of the central bank. Central
Bank uses various methods of Credit Control from time to time and
thus influences the banks to expand or contract credit.
External Drain
External Drain refers to withdrawal of cash from the banking system by the
public. It lowers the deposits/reserves of the banks and limits the credit
creation
Uniform Policy
If all the commercial banks follow a uniform policy related to CRR, then
credit creation would be smooth. If some banks follow liberal and others
follow a conservative one, then credit creation would be affected
Objectives of Monetary Policy
The primary objective of monetary policy is to maintain price stability

while keeping in mind the objective of growth.
 Price stability is a necessary precondition to sustainable growth.
Fed’s Tools of Monetary Control
 Influences the quantity of reserves

 Open-market operations
 Fed lending to banks
 Influences the reserve ratio
 Reserve requirements
 Paying interest on reserves
 Open-market operations
 Purchase and sale of U.S. government bonds by the Fed
 To increase the money supply
 The Fed buys U.S. government bonds
 To reduce the money supply
 The Fed sells U.S. government bonds
 Used more often
Fed lending to banks

• To increase the money supply
• Discount window
 At the discount rate
 Term Auction Facility
 To the highest bidder
The discount rate

 Interest rate on the loans that the Fed makes to banks
 Higher discount rate
 Reduce the money supply
 Smaller discount rate
 Increase the money supply
 Reserve requirements
 Regulations on minimum amount of reserves
 That banks must hold against deposits
 An increase in reserve requirement
 Decrease the money supply
 A decrease in reserve requirement
 Increase the money supply
 Used rarely – disrupt business of banking
Paying interest on reserves

 Since October 2008
 The higher the interest rate on reserves
 The more reserves banks will choose to hold
 An increase in the interest rate on reserves
 Increase the reserve ratio
 Lower the money multiplier
 Lower the money supply
The Federal Funds Rate
The federal funds rate

 Interest rate at which banks make overnight loans to one another
 Lender – has excess reserves
 Borrower – needs reserves
 A change in federal funds rate
 Changes other interest rates
The Federal Funds Rate
Fed: target the federal funds rate

 The Fed buys
 Decrease in the federal funds rate
 Increase in money supply
 The Fed sells
 Increase in the federal funds rate
 Decrease in money supply
Problems
The Fed’s control of the money supply

 Not precise
The Fed
 Does not control the amount of money that households choose to hold as deposits in
banks
 Does not control the amount that bankers choose to lend
Inflation Target
Definition of Price Stability:

In Feb 2015, Government has given RBI an inflation target: to keep CPI

inflation at 4% with a band of + and - 2%.
 If inflation higher than 6% or lower than 2% for 3 consecutive quarters, RBI
has to issue an explanation.
Government has constituted a Monetary Policy Committee (MPC)
 6 members
 3 from RBI
 3 external experts
 Veto vote of the Governor
The RBI’s Tools of Monetary Control
The RBI has several tools in its monetary toolbox:

 Bank rate
 CRR
 SLR
 Repo Rate under Liquidity Adjustment Facility (LAF)
 Reverse Repo Rate under LAF
 Marginal Standing Facility
The of
The RBI’s Tools RBI’s Tools Control
Monetary of Monetary Control
Changing the Bank Rate Rate

 The discount rate is the interest rate the RBI charges from banks for loans.
 Increasing the discount rate decreases the money supply.
 Decreasing the discount rate increases the money supply.
TheofRBI’s
The RBI’s Tools ToolsControl
Open-Market Operations
 The RBI conducts open-market operations when it buys government bonds from or
sells government bonds to the public:
 When the RBI buys government bonds, the money supply increases.
 The money supply decreases when the RBI sells government bonds.
TheofRBI’s
The RBI’s Tools ToolsControl
Cash Reserve Ratio (CRR)

 The RBI also influences the money supply with reserve requirements.
 Reserve requirements are regulations on the minimum amount of reserves that banks must
hold against deposits.
 Increasing the reserve requirement decreases the money supply.
 Decreasing the reserve requirement increases the money supply.
Statutory Liquidity Ratio (SLR)

 Apart from Cash Reserve Ratio (CRR), banks have to maintain a stipulated proportion of
their net demand and time liabilities in the form of liquid assets like cash, gold and
unencumbered securities. Treasury bills, dated securities issued under market borrowing
programme and market stabilisation schemes (MSS), etc also form part of the SLR.
Liquidity Adjustment Facility (LAF)
LAF has emerged as the principal operating instrument for

modulating interest rates in the economy.
LAF was introduced with the first stage starting from June 2000
onwards.
LAF is open market operations for a short-term duration: daily and
weekend.
LAF is used to aid banks in adjusting the day to day mismatches in
liquidity.
LAF consists of repo and reverse repo operations.
Repo or Repurchase option
Is a collateralised lending i.e. banks borrow money from RBI to meet
short term needs by selling securities to RBI with an agreement to
repurchase the same at predetermined rate and date.
The rate charged by RBI for this transaction is called the repo rate.
Repo operations therefore inject liquidity into the system.
Reverse repo
When RBI borrows money from banks by lending securities.

 The interest rate paid by RBI in this case is called the reverse repo rate.
Reverse repo operation therefore absorbs the liquidity in the system.
The collateral used for repo and reverse repo operations comprise of
Government of India securities.
Marginal Standing Facility (MSF)
Banks can borrow additional amount of overnight money from the

Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR)
portfolio up to a limit at a penal rate of interest.
This provides a safety valve against unanticipated liquidity shocks to
the banking system.
Marginal Standing Facility (MSF) = Repo + 0.25%
Policy Rates
Policy Repo Rate : 4.00%
Reverse Repo Rate : 3.35%
Marginal Standing Facility Rate : 4.25%
Bank Rate : 4.25%
CRR 3%
SLR 18.00%
How does IT work?
 RBI changes repo rate based on an assessment of the macroeconomic and

liquidity conditions.
 Mainly worried over inflation
 Repo rate changes transmit through the money market.
 Money market: for short-term lending/borrowing between banks and FIs.
 From the money market they transmit to the entire financial system.
 Financial system channelizes savings towards investment and consumption and
then to output.
 Thus, change in interest rates leads to changes in money supply, investment,
consumption, output.
Example
Say inflation rises from 6% to 7%.

1. RBI MPC raises repo rate from 6.25% to 6.5%
2. The higher repo rate leads to higher rates in money markets.
Example...
Example…
3. Higher money market interest rates lead to higher interest rates by

banks.
4. Higher interest rates leads to lower investment and lower
consumption.
5. This leads to lower demand for goods and money.
6. This leads to lower prices.
7. Lower prices lead to lower inflation.
8. Inflation comes back to 5%.
Opposite happens in case of lower inflation.

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Chpater 29

The Monetary System

Money is the stock of

1. Medium of Exchange: we use it to buy things (goods and services).

Deputy Governors (4)

Principal Chief General Managers

Chief General Managers

Assistant General Managers

The governor is Reserve Bank’s Chief executive.

No stapling, writing, excessive folding

Three Primary Functions of the RBI

 Conducts monetary policy by setting the interest rates.

Government needs a banker to carry out its financial transactions in an

Regulating transactions related to external sector and facilitating

Money Supply is the quantity/amount of money which is in circulation

Narrow Money (M1) and Broad Money (M3) in Rupees crores

Narrow Money Broad Money

Federal Reserve (Fed)

The Fed’s jobs

The Fed’s jobs

Fed’s primary tool: open-market operation

The simple case of 100% reserve banking

Total Money Supply: 100+90+81=$271

The money/credit multiplier

 Total money supply = S = a/(1-r) where 0< r<1 = 100/(1-

The money multiplier

The higher the reserve ratio

If bank’s assets – rise in value by 5%

If bank’s assets – reduced in value by 5%

Banks in 2008 and 2009

 Reduce lending (credit crunch)

U.S. Treasury and the Fed

Cash Reserve Ratio (CRR)

Banking Habits of People

Willingness of people to borrow

Monetary Policy of Central Bank

The primary objective of monetary policy is to maintain price stability

 Influences the quantity of reserves

Fed lending to banks

The discount rate

Paying interest on reserves

The federal funds rate

Fed: target the federal funds rate

 Decrease in money supply

The Fed’s control of the money supply

Definition of Price Stability:

The RBI has several tools in its monetary toolbox:

Changing the Bank Rate Rate

Cash Reserve Ratio (CRR)

Statutory Liquidity Ratio (SLR)

LAF has emerged as the principal operating instrument for

When RBI borrows money from banks by lending securities.

Banks can borrow additional amount of overnight money from the

Policy Repo Rate : 4.00%

Reverse Repo Rate : 3.35%

Marginal Standing Facility Rate : 4.25%

Bank Rate : 4.25%

 RBI changes repo rate based on an assessment of the macroeconomic and

Say inflation rises from 6% to 7%.

3. Higher money market interest rates lead to higher interest rates by

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