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Session 8 and 9 Money, Money Supply, and Money Demand
Session 8 and 9 Money, Money Supply, and Money Demand
Session 8 and 9 Money, Money Supply, and Money Demand
Money Demand
What is money?
• In economics
– money = medium of exchange
– Whatever is accepted in exchange
• Store of value
– An asset that maintains value, transfers purchasing power from present to
future
– If money were not a store of value, it would not be used as a medium of
exchange. It essentially store purchasing power (thought not perfectly due to
inflation) to buy goods in future.
• Unit of account
– The unit in which prices are quoted
• Issues
– For low value commodity, you require large amount
(physically)of money to make transactions
– Also, transporting money was not easy. Verifying the
quality of money was costly
Development of Money: Fiat Money
• Today money is not backed by any physical asset.
• Hence, there is no intrinsic value of the money.
• Yet the notes says that I promise to pay the bearer
sum of X Rs.
Development of Money: Fiat Money
• It helps in avoiding the sharp fluctuations of money supply
depending upon the new discoveries of the metal
• M1: Currency (notes and coins with public) + Demand deposits (current and
saving deposits)
• M2: M1 + office savings banks
• M3: M2 + time deposits
– M1 is called as the narrow money while M3 is defined as broad money.
M=C+D
Money Supply Currency Demand Deposits
• Earlier, they use to charge interest for deposits, now they could
give the interest on deposits.
Fractional-Reserve Banking
• The banks maintains a fraction of their deposits as
reserves to meet the withdrawal demand of the
depositors, and lent out the rest of the money
M
M= m BB
=m
Because
Becausethe
themonetary
monetarybase
basehas
hasaamultiplied
multipliedeffect
effecton
onthe
themoney
money
supply,
supply,the
themonetary
monetarybase
baseisisalso
alsocalled
calledas
asthe
thehigh-powered
high-poweredmoney.
money.
Money Stock Determination
(When Public holds currency)
• The RBI has direct control over high powered money (H)
• Money supply (M) is linked to H via the money multiplier
– Bottom of figure is the stock of high-powered money = monetary base
• Money multiplier (mm) is the ratio of the stock of money to the
stock of high powered money mm > 1
re reserves
– Reserve ratio: D
1 cu
mm
• Money multiplier = re cu
Money Stock Determination
• Some observations of the money multiplier:
1 cu
mm
re cu
• Banks may hold some excess reserves over and above legal requirements to
meet unexpected withdrawals which otherwise could bring down their
reserve ratios below legal requirements
• Reserves (in India) earn no interest, so banks try to minimize excess
reserves, especially when interest rates are high
(In the US, the Fed started paying interest on reserves after 2008 financial crisis. The current
interest rate is 0.1 %).
Calculate Money Multiplier
• If the required reserve ratio is 8%, the excess
reserve ratio is 2%, and the currency-deposit ratio
is 30%, what is the value of money multiplier?
• Notice, that banks are the only financial intermediary who can
create money by making loans
• Presume that you lend money Tata by corporate bonds. Tata can
use that money to buy cement, but you cannot use the piece of
the corporate bond to purchase goods in a grocery shop
• Bank changed the interest rate, and if you now invest fresh Rs 1000,
you will get 8% interest only on incremental deposits.
• The CRR was preferred tool in till 1990s when the SLR was
very high and bond markets were not liquid
• Currently, it is not a preferred policy tool as OMOs can be
calibrated and timed according to liquidity conditions
Open Market Operations (OMOs)
• The Central Bank manages money supply through OMOs
– Purchase government bonds: To add money supply (increase liquidity)
– Sell government bonds in the open market: To reduce money apply
(absorbs liquidity)
• Reverse Repo
– Central bank sells the bonds and in return commercial banks
gives currency to the central bank. Now bank has less currency.
To maintain the reserve ratio (currency in vault/held at central
bank as % of the deposits), banks need to reduce their loans.
Banks start making fresh loans, a part of which is retained by the public as cash, remaining is
deposited back, banks keep required reserves and lent out the rest (process continues)
Commercial Bank's Balance Sheet (stage 2)
RBI's Balance Sheet (Stage 2) Demand
Currency held Reserves 102 Deposits 1020
Securities 206 by Public 204 Loans 624
100 102 Government
Other Securities 294
Assets Bank Reserves
Repo
Round Loan Reserve Cash Deposits
1 6 1 5
2 4.5 0.5 0.75 3.75
3 3.375 0.375 0.5625 2.8125
- - - - -
- - - - -
Sum 24 2 4 20
• Overall Impact
– Households’ cash holding goes up by Rs 4 Cr, while the total money supply goes up
by Rs 24 Cr
Reverse Repo
Commercial Bank's Balance Sheet (stage 2)
RBI's Balance Sheet (Stage 2) Demand
Currency held Reserves 102 Deposits 1020
Securities 206 by Public 204 Loans 624
100 102 Government
Other Securities 294
Assets Bank Reserves
RBI sells government securities worth 6 Cr to the banks
Commercial Bank's Balance Sheet (Stage 3)
RBI's Balance Sheet (Stage 3) Demand
Currency held Reserves 96 Deposits 1020
Securities 200 by Public 204 Loans 624
Other Assets 100 Bank Reserves 96 Government
Securities 300
Banks start reducing their lending to boost reserves. Any repayment to the bank reduces both
lending as well as deposits/cash in the system. Thus, both lending and deposits come down,
while reserves increases
Commercial Bank's Balance Sheet (Stage 4)
RBI’s Balance Sheet (Stage 4) Demand
Government Currency held Reserves 100 Deposits 1000
Securities 200 by Public 200 Loans 600
100 100 Government
Other Assets Bank Reserves
Securities 300
Reverse Repo
• Overall Impact
– Households’ cash holding decline by Rs 4 Cr, while the total money supply reduces
by Rs 24 Cr
CRR vs OMO
• Both have impact on money supply
Since an open market purchase valued at $40 million would increase high-powered
money (H) by $40 million, money supply (M) would increase by $130 million.
Quantitative Easing and Exploding Monetary Base
The monetary base has historically grown relatively
smoothly over time, but from 2007 to 2014 it
increased approximately 5-fold. The huge expansion
in the monetary base, however, was not
accompanied by similar increases in M1 and M2
• The cost of borrowing from other banks is the federal funds rate/interbank
call market rate
– Federal funds are reserves that some banks have in excess and others
need
• Banks have assets (long term loans) which are bit illiquid but liabilities are
liquid (deposits are short term): (Liquidity vs Solvency)
• If depositors come to know that their bank does not have sufficient cash,
they may bank run to get their cash back, further worsening situation.
• One bank may have borrowed from other banks, leading to spill over effect
or contagion effect.
(Billion USD)
(Billion USD)
• Bank “sold” these loans to other financial institutions to get money and make more loans.
New innovation was mortgage backed securities (MBS).
• Banks seized the houses and auctioned them. Supply of houses increased with falling
demand. House prices fell. Other home loan borrowers found themselves underwater (their
house were worth less than the loans) and defaulted.
• The banks that gave housing loans and financial institutions that have purchased the MBS
also suffered.
• The interbank lending market froze, creating troubles for even solvent banks.
• Fed played the role of lender of last resort, and flooded liquidity in the market by quantitative
Fiscal Deficit and Monetary Policy
• Fiscal deficit is the excess of government spending
(including transfers) over its tax collection
Liquidity
Adjustment
Liquidity Facility
Adjustment
Facility
(LAF)
(LAF)
https://rbi.org.in/Scripts/BS_ViewMMO.aspx#:~:text=*%20Net%20liquidity%20is%20calculated%20as,SLF
%2DReverse%20Repo%2DSDF.
https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49352
https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49343
M CU D
H CU R
Aggregate demand
E2 Ā+c(1-t)Y-bi2
i2< i1
Ā-bi2 Ā+c(1-t)Y-bi1
Reduction in interest
Ā-bi1 E1 rate and subsequent
increase in investment
moves the aggregate
Y1 Y2 Y demand upward.
Income, output
(a)
A
i
Interest rate
i1 E1
i2 E2
I1 I2
Investment
Reducing Interest Rate in Recessions
Demand for Money
• What is money? Why does anyone want it?
• Why would anyone want money instead of other interest-
bearing assets/physical assets?
15-74
Speculative Demand for Money
• Focuses on the store-of-value function of money → money
in the investment portfolio of an individual
• Wealth held in specific assets → portfolio
– Due to uncertainty, unwise to hold entire portfolio in a single
risky asset → diversify asset holdings
• Money is a safe asset, but gives zero nominal interest rate.
– Demand for money depends upon the expected yields
(opportunity cost) and riskiness (expectation of change in yield
i.e. price) of other assets (James Tobin)
Increase in the opportunity cost of holding money lowers money
demand
Increase in the riskiness of the returns on other assets increases money
demand
15-75
Transaction Velocity of Money
• M VT = PT
• where
• M = Monetary stock (M3)
• P = Price value of a typical transaction
• T = Total number of transactions where goods/services are exchanged for money
• VT = number of times the money changes hand during the given period
• Figure shows M2 velocity (left scale) and the Treasury bill interest rate (right
scale)
– Velocity is relatively stable, as left-hand scale is only between 1.5 and 2.2 over a 40
year period
– Velocity has a strong tendency to rise and fall with market interest rates
– Over the last decade M2 velocity has become much less stable than in the past
15-79
The Quantity Theory (M V = PY)
• The quantity theory of money provides a very
simple way to organize thinking about the
relation between money, prices, and output:
15-80
The Quantity Theory
• The classical quantity theory = theory of inflation
– The price level is proportional to the money stock:
V M
P
Y
• Milton
Friedman
But it always
has fiscal
origins
Governments
unable to
collect taxes
starts printing
press
Money Demand and High Inflation
• Would you like to hold your savings in form of
money