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Subject ECONOMICS
Paper No and Title 11 - MONEY AND BANKING
Module No and Title 5- High powered money
Module Tag ECO_P11_M5

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Factors Affecting H
3.1 Net reserve Bank Credit to Government

3.2 Reserve Bank Credit to Banks.

3.3Reserve Bank Credit to the Commercial sector
3.4Net Foreign Exchange assets of the RBI
3.5. Net Non Monetary Liabilities of the RBI

4. Adjusted High Powered Money

5.Summary

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1. Learning Outcomes
After studying this module, you shall be able to

Know about the High poweredmoney(H) in detail

Learn about the components of and factors affecting H
Identify the impact of changes in cash reserve ratio on High Powered Money
Evaluatethe relative importance of the factors affecting H
Analyse ..the impact of adjusted H on the money supply in the economy.

2. Introduction

High Powered Money

The discussion of thedeterminants of money supply in the earlier modules were identified as
High powered money and the money multiplier.Amongst these two,H is found to be the principal
determinant and the money multiplier is found to be stable and predictable over time.Though we
had assumed H as policy determined and exogenously given,it is not so in actual life.In this
module therefore we look at the factors affecting H

3. Factors affecting H

We start by recalling that H represents the monetary liabilities of R.B.I and the GOI and
is the money produced by the RBI and the government and seized by the public and
banks .The supply of High Powered therefore can be represented.as the government
currency( GC) and Reserve Bank Money( RBM ).They are held by the public and
banks.In India

H = GC + RBM,

Government currency consists of one rupee notes and coins and smaller denomination
coins. RBM comprises of all currency notes( other than one rupee notes),deposits of
banks with the RBI and other deposits of banks with the RBI(OD)The structural
composition of H reveals that the proportion of government currency in the hands of the
public and banks is a small proportion of the total stock of H outstanding., hence most of
the observed changes in H are due to changes in RBM which is also the monetary
liability of the RBI.

The complex of forces affectingH are the resultof transactions of the RBI with the various
sectors of the economy and the world,in performance of its central banking
functions,Thus it acts as a banker to the Government,as a lender of last resort ,or as a
bankers bank for the commercial and cooperative banks and as the ultimate custodian of
the countrys foreign exchange reserves.In addition it also makes funds available to the
commercial sector via the various development banks.

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The framework by which we study the operations of the

various factors responsible for changes in R.B.M requires first,an analysis of the balance
sheet of the R.B.I.

MonetaryLiabilities(ML)+Non Monetary Liabilities(NML) =Financial Asset(FA) +

Other Assets(OA).

If, NetNon-Monetary Liabilities(NNML) = NML OA

RBM=ML = FA - NNML

These Monetary Liabilities are the RBM and the factors affecting them could be identified as
factors affecting financial assets and the NNML. Financial Assets are what the central bank
acquires as a part of its central banking functions with other sectors like the
Government,banks,development banks and the foreign sector.

The RBI provides them its credit, acquires financial assets and creates RBM in the process

RBM = (1) Net RBC to the governmentI

+(2) RBC to Banks

+(3) RBC to Development Banks

+(4)Net Foreign exchange assets of theRBI

- (5)Net Non Monetary Liabilities of the RBI

These will now be discussed individually

3.1 Net Reserve Bank Credit to the Government

The RBI is a banker to both the central and state government. It invests in the Treasury
bills & other securities of the central Government and gives advances to the state
government.

The Gross Reserve Bank Credit to the government is in the form of (1) adhoc and regular
treasury bills and other securities of any maturity held by the RBI in its issue
department,(2)Treasury bills purchased and discounted ,(3) Investment in dated
Governent Securities ,(4)Rupee coins in the Issueand Banking Department of the RBI
and (5) loans and advances given to the state Government

.Till 1997, the central government could ,borrow any amount from the RBI. The state
governments had a limit to their borrowing but often ended up with.

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Unauthorizedoverdrafts. These were cleared by the state

Governments asking for increased plan assistance at the time of the Budget from the
Central Government.The Central Government would use their unlimited powers to
borrow from the RBI to ultimately clear the overdrafts.

However the situation has changed post a historic agreement reached between the RBI
and the Government in 1997.The issue of adhoc treasurybills by the Government were
discontinued and were replaced by Ways and Means advances to the central government.
There was also a limit on the amount that could be borrowed by the Government from
the RBI through the issue of regular Treasury Bills.

The central and state governments keep their deposits in an interest free account with the
RBI.These deposits are subtracted from gross RBC to the government to get net RBC to
the government..This is a roughfigure for gross deficit financing of the governmentor
monetization of public debt and is a very important determinant of changes in H.

3.2 Reserve Bank Credit to Banks

The RBI gives credit to Scheduled Commercial Banks in two forms.Either (1) as loans &
advances against government securities,usance bills or promissory notes as collateral, or
(2through the purchase or rediscounting of internal commercial bills as well as treasury bills

The rate at which loans and advances are given is called the bank rate and the rate at which the
discounting is done is called the discount rate.Generally , the Bank rate and the discount rate is
the same percentage, but they are two different ways through which the RBI gives credit to banks.

.The scheduled commercial bankskeep their required reserves as balances with the RBI and are
hence entitled to a certain amount of credit from the RBI which the RBI cannot refuse. This is
called the non discretionary component of the RBI Credit to banks. If the banks desire credit
more than this amount, the RBI can refuse the credit, hence this is known as the discretionary
component of the RBI credit to Banks

3.3 Reserve Bank Credit to Development Banks/Commercial Sector

The development banks have been set up by the RBI to provide medium and long term credit to
agriculture and industry.They provide credit to the commercial sector.The development banks are
the immediate recepients of credit from the RBI while the commercial sector is the final recipient
of credit.

The RBI gives credit to development banks by either (1) giving them loans and advances against
government securities as collateral,or(2) by investing in the shares /debentures/bonds issued by
the NBFI like the IDBI,NABARDor (3) by purchasing and rediscounting the internal
commercial bills of exchange under bill rediscounting scheme

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Like the scheduled commercial banks,there is an amount/credit

which Development Banks are entitled from the RBI.This is
the non discretionary quota of Reserve Bank Credit to Development banks which the RBI cannot
refuse,any demand for credit over and above this amount can be refused by the RBI and is hence
called the discretionary quota of Credit from the RBI to Development Banks..This also leads to
generation of H

3.4 Net Foreign Exchange Assets of the RBI

The Gross Foreign exchange assets of the RBI consists of (1) Gold Coin and Bullion
(2)Foreign Securities including those held in the Investment account by the RBI and (3)
Balances held abroad.From this Gross foreign exchange assets we subtract the Foreign
Exchange Liabilities consisting of (1)Indias contribution to IMF account no 1 quota
subscription to get the Net Foreign exchange Assets of the RBI

Any Surplus or Deficit in the Balance of Payments with the RBI gets reflected in the
foreign exchange assets with the RBI

3.5 Net Non Monetary Liabilities of the RBI

The net RBCto the various sectors discussed above ,are financed by the RBI partly by creating its
monetary Liabilities (RBM) and partly by its net non monetary Liabilities(NNML).The larger
these non monetaryresources of the RBI,the less it has to depend upon the creation of new H to
financeits credit to various sectors.Hence this factor enters the equation of factors affecting RBM
with a negative sign.

The NNML of the RBI = NML of the RBI OA of the RBI .

The Other Assets of the RBI consist of (1) Premises (2) Furniture (3)Advances to certain
Scheduled commercial banks with respect to their Investment abroad

The Non-Monetary Liabilities consists of -

(1) Paid up capital of 5 crores

(2)Reserves of 150 crores

(3)contribution to the 3 National Funds maintained by the RBI consisting of the national
agricultural Credit Long Term Operation Fund and stabilization fund and the national
Industrial credit Fund maintained outof the annual income of the RBI ,

(4) The RBI Employees pension fund ,provident fund and the cooperative guarantee fund

(5)Balances under the compulsory deposit scheme

(6)Portion of Indias quota subscription and some other payments inIMF Account No 1

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(7) Profits of the RBI temporarily held

Is H an autonomous Policy determined Variable or an Endogenous Variable.

While discussing the H Theory of Money Supply we had assumed that H was
exogenously determined by the monetary authority.This is only partially true
because in India the Monetary authority consists of both the RBI and the
Government.The RBI however is not autonomous of the government and till
recently, RBI had no control over the deficit financing of the government.

H is not a fully policy determined variable,because it is the result of decision of the

monetary authorities , the public as well as the banks which lead to the generation
or destruction of H.

Banks and development banks can change.H by varying their borrowing from the
RBI,Net purchase or sale of foreign exchange by the public also change
H.Despitethis.because of the vast powers of monetary control by the RBI and the
government, variations in the stock of H*(adjusted H) are directly within the close
control of the authorities,so that H* can be called a policy controlled variable

From Policy point of view all changes in H can be classified in two categories (1)autonomous or
Discretionary changes in H i.e H1 and (2)endogenous or non discretionary changes in H
i.e H2and hence all changes in H =change in H1 + changes in H2

Autonomous changes in H are determined directly by the policy making authorities the
government and the RBI.They are,

(a)Changes in RBH due to government gross of the 3rd item below and including changes arising
from OMO of the RBI

(b)Changes in the discretionary component of the RBH due to banks and Development banks

(c)Net Purchase or sale of foreign exchange and gold by the Government from the public

(2)The Non Discretionary Component or the Endogenous part of the changes in H or H2are
decidedby the public, banks and development banks,given the terms and conditions
under which the RBI is willing to produce such changes.They arise as a result of certain
central banking functions of the RBI towards the public and banks like being a bankers
bank and the controller of all foreign exchange reserves of the country .They consist of

(a)Changes in the government currency held by the public( because RBI is the sole agency
issuing rupee coins and small coins to the public on behalf of the government).

(b) Changes in the non discretionary component of the RBM due to banks and developments
banks

(c) Net purchase or sale of foreign exchange by the public

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4. Adjusted High Powered Money

4.1 The changes in the statutorily required cash reserve ratio ( CRR ) affect the amount of
disposable H available to the banks and the public because these changes either impound
or release reserves of banks.When the CRR is revised upward some reserves are
impounded by the RBI and when the CRR is revised downwards,some reserves get
released.Impounding of reserves reduces and releasing of reserves increases the amount
of disposable.This disposable H is called adjusted H.

The cash reserve ratio is also one of the proximate determinants of the money
multiplier.When the ratio is revised upward,the expression of the narrow and broad
multiplier m1 and m3 decreases leading to lower multiple expansion of bank deposits on
account of enhanced reserve ratio.

However to discuss the impact of H on money supply,we shouldmake the money

multiplier invariant to changes in CRR and adjust H to incorporate the effect of the
reserve ratio changes.This makes the money multiplier an independently determined
variable as far as the monetary authority is concerned.

The CRR is a monetary tool which is often levied as an average percentage of Demand
and time liabilitiesof a bank over a fortnight as well as incremental CRR which is
levied on the increment to the demand and time liabilities after a base date.when
the averageor ICRR is raised/lowered, bank reserves are absorbed/released:or a
part of H is not/is available for deposit creation compared to the base period .and
hence H has to be adjusted.The adjusted H decreases/increases as less/more
reserves are available for deposit creation.

The adjustment factor is = ( rt r0 )D + IR DF where

rt = current cash reserve ratio CRR

r0 = initial or benchmark CRR

D = Demand and Time Liabilities relevant for the computation of CRR

DF = net CRR default for all commercial banks

IR=Incremental Reserves.

This adjustment factor is a measure of the bank reserves liberated or absorbed by the
change in the reserve requirements compared with the base period and
theAdjusted Reseve Money

H* =H --- Adjustment Factor.

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If the CRR increases ,this implies that the adjustment

factor increases and this implies that a part of H is removed from deposit
Creation.

There are two additional assumptions we need to relax

(1)Banks hold Excess Reserves over and above the amount required as part of the CRR
requirement by theRBI,When the banks hold desired Excess Reserves and does
not lend them,they create no deposit and hence no increases in Money Supply
takes place.That is ,the desired ER in the Banking System are an idle component
of reserves R that arenot being used to support any deposits,and therefore such
reserves should be subtracted from the reserve money and focus on the amount
actually supporting the money supply.

(2)Banks can also borrow from the RBI in the form of discretionary finance or discount
loans.This augments their capacity for deposit creation because the banksdo not
have to keep any amount aside as required reserves and lend the entire
amount.This discretionary finance to the banks should be added to the stock of
reserve money.

The General model of money multiplier can be given as

M3 = [1+c +t][c+r (1 +t)]-1[H* +df ER]

Where H* = Non Borrowed Reserve Money

Df = Discretionary Finance provided

ER = desired excess Reserves

. Summary

The concept of High Powered Money and its components

The Factors affecting H which are

Net Reserve Bank Credit to the Government

Reserve Bank Credit to the Banks
Reserve Bank Credit to the commercial sector/development banks
Net Foreign exchange Assets of the RBI
Net Non Monetary Liabilities of the RBI

The concept of adjusted H due to impact of changes in CRR on H

Impact of adjusted H on the Money Supply in the economy

ECONOMICS PAPER No. : 11 MONEY AND BANKING

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ECONOMICS PAPER No. : 11 MONEY AND BANKING

MODULE No. : 5 HIGH POWERED MONEY