Topic 5a

Money in the Indian Economy

Overview

Money in the Indian economy The Reserve Bank of India and its functions Fractional reserve banking - how does it work? The money multiplier Tools of Monetary control

Money in the Indian Economy

Money Stock is the quantity of money circulating in the economy. Different ways of measuring the money stock in the economy: M0 = H Reserve/base Money
(also called High Powered)

M1 = C + DD + OD Narrow Money M3 = M1 + TD Broad Money

Where C =Currency DD = Demand (current) deposits OD =other deposits , TD = Time (Fixed) Deposits

Measurement of Money
The most familiar form of money - called narrow money - used includes: Currency Other Deposits (OD) Demand Deposits (DD) Rs. 422843 on March 31, 2002 - approx. 4248 per capita Rs. 473581 on March 31, 2003 Rs. 578716 on March 31, 2004 Rs. 646263 on March 31, 2005

M1

is it stock or flow?

Measurement of Money

A broader measure of money than M1, includes:

M1 + Personal Term Deposits Rs 1498355 on March 31, 2002 of Indian currency outstanding Rs 1717960 on March 31, 2003 Rs. 2005676 on March 31, 2004 Rs. 2253938 on March 31, 2005

M3

is it stock or flow?

Quick Quiz!
List and describe the four functions of money.

The Reserve Bank of India

The Reserve Bank Of India (RBI) serves as the nations central bank, which is designed to control the quantity of money in the economy. The RBI is owned by the Indian government, established in 1935 by an Act of Parliament.

Ref. www.rbi.org.in

The RBIs Organization

The RBI is run by its Board of Governors which is composed of:

The Governor. Three Deputy Governors.

All members are appointed by the Finance Ministry.

The RBIs Organization

The RBI is controlled by the Govt. of India which appoints the Board of Directors. As a last resort the government can issue a written directive to the Governor with which he must comply. In practice the Reserve Bank of India is largely independent of the government is it good or bad?

Central Bank Independence

In practice

RBI is largely independent of the Government

What

about

Japan U.S.A. New Zealand Germany U.K. Canada China

4 Primary Functions of the RBI

Issue currency. Act as a bankers bank, making loans to other banks and as a lender of last resort. Act as banker to the Government of India. Control the money supply with monetary policy.

Money Supply Changes by the RBI

Open-Market Operations: The primary way in which the RBI changes the money supply is done through the purchase and sale of Government of India bonds. - To increase the money supply, the RBI buys
government bonds from the public.

- To decrease the money supply, the RBI sells government bonds to the public.

Tools of Monetary Control

The RBI has 3 instruments of monetary control:

Open-Market Operations:

Buying and selling bonds.

Changing the Reserve Ratio (CRR, SLR):

Increasing or decreasing the ratio.

The interest rate the RBI charges other banks for loans.

Changing the Bank Rate:

Ref: RBI Tables -Handout

Quick Quiz!

How does the RBI increase the supply of money in the economy?

Overview

The functions and measurement of money The Reserve Bank of India and its functions Fractional reserve banking - how does it work? The money multiplier Tools of Monetary control

Banks and The Money Supply

The behaviour of banks can influence the quantity of demand deposits in the economy and therefore, the money supply. Fractional Reserve Banking System: The practice of holding a fraction of money deposited as reserves and lending out the rest.

Fractional Reserve Banking

Deposits into a bank are recorded as both assets and liabilities. Deposits that have been received but not lent out are called reserves. The supply of money in the economy is affected by the amount of deposits that are kept in the bank as reserves and the amount that is lent out. Loans become an asset to the bank.

Bank T-Account Example

First National Bank
Assets Liabilities

Reserves Deposits Rs10.00 Rs100.00 Loans Rs90.00

Total Assets Total Liabilities Rs100.00 Rs100.00

Bank T-Account Example

First National Bank
Assets Liabilities A T-Account illustrates the financial position of a bank that accepts deposits, keeps a portion as reserves and lends out the rest.

Reserves Deposits Rs10.00 Rs100.00 Loans Rs90.00

Total Assets Total Liabilities Rs100.00 Rs100.00

Multiple-Bank Expansion of Money

Money Creation with Fractional-Reserve Banking

When a bank makes a loan (from its reserves) the money supply increases. When banks hold only a fraction of deposits in reserve, banks create money. The creation of money through loans does not create any wealth, but allows banks to charge interest several times on the same bit of wealth.

The Money Multiplier

When one bank loans money, that money is generally deposited into another or the same bank thus creating more deposits and more reserves to be lent out. The Money Multiplier is the amount of money that the banking system generates with each Rupee of reserves.

Irony of Bank / Financial Institution 1

A BANK is an institution which will not be able to pay back all its liabilities if all its depositors would want it at one point of time. This could cause the problem of BANK RUN if central bank doesnt protect them. This could also potentially lead to crisis of confidence in the banking system and it could lead to collapse of the financial system. Recent example in the Indian context was
of ICICI bank. In 1930s the depression was worsened becoz of this.

The Money Multiplier

First National Bank
Assets Liabilities

Reserves Deposits Rs10.00 Rs100.00 Loans Rs90.00 Total Assets Total Liabilities Rs100.00 Rs100.00

The Money Multiplier

First National Bank
Assets Liabilities

Second National Bank

Assets
Reserves Rs9.00

Liabilities
Deposits Rs90.00

Reserves Deposits Rs10.00 Rs100.00 Loans Rs90.00 Total Assets Total Liabilities Rs100.00 Rs100.00

Loans
Rs81.00 Total Assets Rs90.00 Total Liabilities Rs90.00

The Money Multiplier

First National Bank
Assets Liabilities

Second National Bank

Assets
Reserves Rs9.00

Liabilities
Deposits Rs90.00

Reserves Deposits Rs10.00 Rs100.00 Loans Rs90.00 Total Assets Total Liabilities Rs100.00 Rs100.00

Loans
Rs81.00 Total Assets Rs90.00 Total Liabilities Rs90.00

The Money Multiplier

First National Bank
Assets Liabilities

Second National Bank

Assets
Reserves Rs9.00

Liabilities
Deposits Rs90.00

Reserves Deposits Rs10.00 Rs100.00 Loans Rs90.00

Total Money Supply = Rs190.00!

Loans
Rs81.00 Total Assets Rs90.00 Total Liabilities Rs90.00

Total Assets Total Liabilities Rs100.00 Rs100.00

The Money Multiplier

How much money is eventually created in this economy?
Original deposit First National lending Second National lending Third National lending Total money supply = Rs 100.00 = Rs 90.00 [=0.9 x Rs 100.00] = Rs 81.00 [=0.9 x Rs 90.00] = Rs 72.90 [=0.9 x Rs 81.00] = Rs. 1,000

What determines the size of the money multiplier?

The money multiplier is the reciprocal of the reserve ratio.

1 With a reserve requirementm = (R) of 20% or 1/5 . . . R

The multiplier will be 5.

R is like MPS in the case of Keynesian multiplier

RELATIONSHIP BETWEEN HIGH-POWERED MONEY AND THE MONEY STOCK (M1 & M3)
Broad Money = M3

Narrow Money = M1

M=C+D

H = Reserve (base) Money M = Money Supply H=C+R C = Currency, R = Reserves with banks M C+D D = Demand deposits --- = --------H C+R M C/D + 1 --- = -------------H C/D + R/D

MONEY Multiplier MODEL

M cdr + 1 cdr = currency-deposit ratio --- = ------------ r r = reserve-deposit ratio H cdr + r r cdr + 1 M = ------------ * H cdr + r r
M=mH
MONEY Multiplier MODEL

Where

cdr + 1 m = -----------cdr + r r

Monetary Base

BANK DEPOSITS

CURRENCY IN CIRCULATION

Money Supply

Overview

The functions and measurement of money The Reserve Bank of India and its functions Fractional reserve banking - how does it work? The money multiplier Tools of Monetary control

Problems in Controlling the Money Supply 2 - problems that the RBI must wrestle that arise due to fractional-reserve banking:
1. The RBI does not control the amount of money that households choose to hold as deposits in banks/NBFI.

Problems in Controlling the Money Supply

1.

The RBI does not control the amount of money that households choose to hold as deposits in banks.

2.

The RBI does not control the amount of money that bankers choose/able to lend.
A)

B)

The RBI does not control how much businesses want to borrow from the banks, e.g. Recession Adverse selection problem Akerlof, Stiglitz