Money Market

(Money and Banking)

T.J. Joseph

What is Money?
A financial asset with the following functions: Medium of exchange:
An asset that individuals acquire for the purpose of trading rather than for their own consumption.

A store of value:
Means of holding purchasing power over time

A unit of account:
Measure used to set prices and make economic calculations
2

What is money?
Money is anything that serves as a commonly accepted medium of exchange Money and Income
What we earn is income, not money Money is used to pay the income

Most liquid Currency Transaction deposits Very liquid Saving deposits Short-term securities Money-market funds Less liquid Long-term bonds Equities Real assets

Money Supply
Narrow (Transactions) Money (M1) = Coins and paper currency + Demand Deposits (or Checkable Deposit), Traveler s Checks, etc.
( Other deposits with RBI (= deposits of UTI, IDBI etc; deposits of foreign central banks/governments etc.) are also a part of M1; statistically very small)

Broad Money (M3) = M1 + time deposits with banks

(Money supply in India usually refers to M3)

Also:

M2 (Near-Money) = M1 + savings deposits of post office

savings bank M4 = M3 + total deposits with post office savings banks

M1: R 1253184 cr r
Curr c wi ublic Other deposits with the RBI 1%

, Marc 2009

D mand deposi s

46% 53%

M3: Rs 4764019 rores, Mar h 2009

Curren y with the publi Time deposits
0% 14%

Demand deposits ther deposits with the R I

12%

74%

Who Determines Money Supply?

Central Bank (RBI):
Determines the monetary base (also known as reserve money, base money, high powered money etc.) by fixing the cash reserve ratio, bank rate, etc.

Commercial Banks:
Create money through multiple expansion of bank deposits based on cash reserves (credit money)

General Public:
Through transactions/exchange of money

Central

ank

Central Bank (Reserve Bank of India, Federal Reserve

System in USA) oversees and regulates the banking system and controls the money supply by determining the monetary base

Three primary functions of the Central Bank:

1)

Regulates banks to ensure they follow the 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. Conducts monetary policy by controlling the money supply

2)

3)

Banking and Supply of Money

The Process of Deposit Creation
Commercial Banks are important source of money supply The money they supply is called Credit money Banks receive deposits from the public

Banking and Supply of Money

Primary Deposits
i)

Savings deposited for the sake of safety of govt. bond

ii) Payment received from the central bank for sale iii) Payment received from abroad and deposited

with the bank

iv) For the convenience in receiving and making

payments

Deposit Creation
The process of credit creation or deposit creation begins with banks lending money out of primary deposits Statutory Reserve Requirements: Portion of primary deposits to be maintained either as (i) Cash Reserve (CRR) with the Central Bank, or (ii) excess reserve (Statutory Liquidity Ratio (SLR)) to meet the cash demand by the depositors

Deposit Creation in a Single Bank System Assume: There is a single bank Accepts only demand deposits SRR is 20% (CRR of 5% and SLR of 15%) Assets of the bank are CRs and loans & advances

Suppose an individual A deposits Rs.1000 with the bank All deposits with the bank are its liability The change in the balance sheet of bank is given as:
Liabilities As deposit Amount 1000 SRR Loans & Investments Total 1000 Total Assets Amount 200 800 1000

The bank will lend the Rs.800 other than the reserve requirements Suppose an individual, B borrow this money. The bank may handover the entire Rs.800 to B or open an account in his name and credit the amount to that account

Suppose B keeps the money safe in the bank and to make payments by cheques whenever he needs Now, bank s deposits increase by Rs.800 and SRR is Rs.160 (20% of 800). Now,
Liabilities As deposit Bs deposit Total Amount 1000 800 1800 Assets SRR (200+160) Loan to B Excess cash reserves Total Amount 360 800 640 1800

Note, the bank has excess cash reserves of Rs.640 now The process of borrowing and lending repeated again.

Suppose the bank lends Rs.640 to another individual, C, and credits the money to his account The balance sheet of the bank now is:
Liabilities As deposit Bs deposit Cs deposit Total Amount 1000 800 640 2440 Assets SRR (200+160+128) Loan to B Loan to C Excess cash reserves Total Amount 488 800 640 512 2440

This process of borrowing and lending is called the process of credit creation or the process of deposit creation

This process of deposit and credit creation continues until the excess cash reserve is reduced to zero, provided no other primary deposits are made
Liabilities As deposit Bs deposit Cs deposit ----------nth deposit Total Amount 1000 800 640 --------000 5000 Assets SRR (200+160+128) Loan to B Loan to C ----------Excess cash reserves Total Amount 488 800 640 --------000 5000

Note that a primary deposit of Rs.1000 leads to the creation of a total deposit of Rs.5000.

Thus, the deposit multiplier equals 5

Deposit Creation in Multiple Banking System

The system works as the same in the case of a single banking system if the person who receive the money keeps it as demand deposits Thus, on the basis of Rs.1000 deposits, the commercial banking system is able to lend by a multiple of 5, when the reserve requirement is 20% The chain of increase in deposits will be as follows: 1000 + 800 + 640 + ..

This is a geometric series and the sum will be equal to 1000 ! 5000 0.20

Enabling factors
The process of multiple expansion deposits has been possible because that what one bank losses is another bank gains Banks are able to keep only a fraction of the deposits in cash why?
(i) No depositor withdraws full amount of his deposit (ii) When depositors draws cheques on their accounts it is not necessary that banks pass out cash to that extent

Thus, there are two types of bank deposits

Primary deposit customers deposit money through the process of lending

Secondary deposits

Limits on deposit creation

Banks do not have infinite capacity to create deposits because of three limitations
(i) The amount of cash that banks have to maintain against the deposits (with the central bank and also to meet the requirements of depositors) (ii) Cash drain or cash leakage. This depends on how widespread the use of cheques in the economy is. (iii) Banks inability to find borrowers

Money Multiplier Approach

Monetary liabilities of RBI:
Currency issued by the RBI (notes of rupees two and above) Reserves held by the commercial banks with the RBI, and Other deposits with the RBI

Central Government also issues money in the form of onerupee notes, coins and small coins (the share is negligible)

Money Multiplier Approach

The monetary liabilities of the RBI plus Government money is known as High Powered Money (H), also called Reserve

Money or Monetary Base

Therefore, H = currency with the public (C) + Reserves (R) + Other deposits with the RBI
Neglecting other deposits with the RBI,

H=C+R

Money Multiplier
The monetary base is the sum of currency in circulation and cash reserves of banks (cash in vaults plus deposits with RBI) It is different from the money supply, bank deposits plus currency in circulation. Each rupee of bank reserves backs several rupees of bank deposits, making the money supply larger than the monetary base.

The money multiplier is the ratio of the money supply to the monetary base.

Money Multiplier Approach

Reserves (R) = Vault Cash + Banks deposits with the RBI = Statutory reserves + Excess reserves
The currency and coins with the commercial banks (in order to meet the business needs of the bank) is treated as Vault Cash (It is equal to the Statutory Liquidity Reserve)

Money multiplier equation is Ms = m.H

where, Ms = money supply (M1, M2 or M3), m = money multiplier, H = high powered money

That is, the total supply of money (Ms) depends on the supply of the high-power money (H) and the money multiplier (m)

Money Multiplier Approach

Now, Money Multiplier,
Where,

m = Ms / H

Suppose Ms = M1 = C + DD
C = currency in circulation DD = demand deposits

Reserves, R = r.DD,
where, reserve ratio, r = R / DD

Now, m = Ms / H = (C+DD) / (C+R) Suppose Ms = M3 = C + DD + TD

Where TD = time deposits

Now, m = M3 / H = (C+DD+TD) / (C+R)

Role of General Public in Money Supply

How to know money supply over a period of time? Velocity of circulation of money the number of times money changes hands Therefore, supply of money over a period of time = the amount of money * velocity of circulation For practical point, we divide the national income by money supply to obtain the income velocity of circulation of money Suppose, in 2008-09 NI at current prices was Rs.36535 crores and the money supply was Rs.7558 crores therefore, income velocity is 4.83

Equation of exchange
During any period the total value of transactions must be the same as the total value of money exchanged Total value of transactions equal total goods and services traded (T) multiplied by their average price (P) Total value of money exchanged equal the amount of money (M) multiplied by the velocity of circulation (V). Equating what is paid and what is received, MV = PT equation of exchange

Replacing T with real NI, Y, we get MV = PY

Money Supply
How does money supply affect GDP?
The value of the GDP is nothing but the sum total of all the transactions (given by the velocity of money) over a period of time GDP, therefore, depends on the stock of money multiplied by the speed with which money changes hands As the stock of money increases, more goods and services will be exchanged and the GDP will rise (a stimulative role) If the economy is already operating in full capacity, increase in money supply will lead to inflation

Money Demand
Money demand is determined by several factors.


According to the theory of liquidity preference, one of the most important factors is the interest rate. People choose to hold money because money can be used to buy other goods and services.

Demand for Money

Reasons for Money Demand
(1) Transactions Demand for Money
That is, to buy goods and services It is a positive function of income (GDP) Higher income higher the demand for money to buy goods and services But it is also a negative function of interest rate

(2) Precautionary Demand for Money

Hold money to meet unforeseen emergencies It is also a positive function of income and a negative function of interest rate

Demand for Money

(3) Speculative Demand for Money
Holding money to make capital gains or avoid capital losses It depends on the people s expectation about bond prices If the current bond prices are low and expected to rise, people will hold less money and buy more bonds (speculative demand for money is low) and vice versa. Conclusion The demand for money is an increasing function of income and a decreasing function of interest rate

Interest Rates: The Price of Money

Interest is the payment made for the use of money or the price paid to borrow money Costs of Holding Money
 The opportunity cost of holding money is the interest that

you would have earned if you invested it

 An increase in the interest rate raises the opportunity

cost of holding money.

 As a result, the quantity of money demanded is reduced.

Interest Rates: The Price of Money

Nominal and Real Interest Rates
Nominal interest rate measures the yield in rupees per year per rupee invested (it is the money value) It does not take into account the changes in the prices or inflation factor Real interest rate is corrected for inflation It is calculated as the nominal interest rate minus rate of inflation E.g.: Nominal interest rate is 8%, Inflation rate is 3%: therefore, the Real interest rate is 8 3 = 5% per year

Equilibrium in the Money Market

Interest Rate Money supply

r1 Equilibrium interest rate r2

Money demand Md 1 Quantity fixed by the RBI Md2 Quantity of Money

Changes in the Money Supply

 The RBI can shift the aggregate demand curve when it

changes monetary policy.

 An increase in the money supply shifts the money supply

curve to the right.

 Without a change in the money demand curve, the

interest rate falls.

 Falling interest rates increase the quantity of goods and

services demanded.

Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.

A Monetary Injection...
(a) The Money Market Interest Rate
Money supply, M S1 MS2

(b) The Aggregate-Demand Curve Price Level

1. When the RBI increases the money supply

3. which increases the quantity of goods and services demanded at a given price level.

r1 r2
Aggregate demand, AD1 AD2

2. the equilibrium interest rate falls

Quantity of Money

Y1

Y2

Quantity of Output

MONETARY POLICY

Monetary Policy
How does a monetary authority decide on when to expand or contract credit and by how much? Decision based on the overall objectives of the monetary policy

Meaning of Monetary Policy

Monetary policy is essentially a programme of action undertaken by the monetary authorities, generally the central bank, to control and regulate the supply of money with the public and the flow of credit with a view to achieving predetermined macroeconomic goals The objectives of monetary policy are the same as of macroeconomic policy price stability, currency stability, financial stability, growth in employment and income

Money Supply
 The money supply is controlled by the RBI through:
 Changing  Changing

the reserve requirements the bank rate operations

 Open-market

Thus the quantity of money supplied does not depend on the interest rate and is vertical.

Instruments of Monetary Policy

Credit Control by the Central Bank
Instruments of credit control
Broadly categorized into two: General instruments are intended to regulate the total volume of credit (quantitative) Include (1) bank rate, (2) open market operations, (3) power to vary the reserve requirements Selective instruments to regulate the purpose for which commercial banks generated credit (qualitative)

Variable Reserve Ratios

Banks are required to maintain a percentage of their deposits in the form of balances with the RBI, known as legal reserve requirement (statutory reserve requirement) RBI has the power to vary this ratio and used as an instrument of credit control An increase in reserve requirement ratio will reduce the reserves for lending by the banks A lowering of the reserve ratio will enable the banks to expand credit The most easiest way to control credit

Bank Rate
The minimum rate at which the central bank of a country provided financial assistance to commercial banks By raising or lowering bank rate, the central bank can reduce or expand credit granted by banks Currently bank rate in India is 6.0%

Bank Rate
How bank rate works?
bank rate cost of borrowing by commercial banks from the central bank in lending rate of commercial banks less borrowing Adverse effect on the level of production and prices Usually used during inflationary situation Similarly, a fall in bank rate lower the lending rates of CBs and lead to expansion of bank credit and may raise income and output

Conditions for successful working of bank rate

A well organized money market in order to have impact on other rates in the market Reactions of borrowers to change in the lending rates A fall in output may coexist with a rise in price Customers assessment of the economic situation. If the business conditions are not favorable lowering of lending rate may not attract much borrowers

Bank Rate in India

Policy Rates
(www.rbi.org.in, 07/06/2010)

Bank rate Repo rate Reverse repo rate

6% 5.25 % 3.75 %

Repo (from the perspective of the seller of a security) or Reverse repo (from the perspective of the buyer of a security) is a Repurchase agreement in which two parties agree to sell and repurchase a security on an agreed date at a predetermined price. When banks sell securities, repo rate is applicable; when banks buy securities to park surplus funds, reverse repo rate is applicable.

Reserve Ratios
(www.rbi.org.in, 07/06/2010)

Cash Reserve ratio Statutory Liquidity ratio

6% 25 %

Open Market Operations

Primary instrument of credit control in developed markets Involve the purchase and sale of securities by the central bank The purchase of securities by a central bank leads to an increase in the bank reserves This leads to a multiple expansion of credit and deposits On the other hand sale of securities by the central bank will reduce bank reserves and lead to multiple contraction of credit This is not used as an instrument of credit control in India, because this market is very narrow in India

Selective Credit Controls

Purpose is to regulate the flow of credit for financing specific activities RBI encourages the flow of credit to agriculture and to other sectors like export For borrowings of CBs to refinance such operations RBI charges a lower interest rate than the bank rate The ultimate objective is to prevent a rise in the price of these commodities with the help of bank credit Selective credit controls have been operation in India against commodities like foodgrains, oilseeds, cotton, etc.

The Effects of Money on Output and Prices

Transmission Mechanism of Monetary Policy
Suppose RBI is concerned about inflation and has decided to slow down the economy Step 1: Suppose RBI reduces reserves with the banks through any of its credit control activity Step 2: Reduction in bank reserves result in a multiple contraction in deposit or credit creation, thereby reducing the money supply

The Effects of Money on Output and Prices

Step 3: Reduction in money supply increases interest rates and tightens credit conditions, and lowers the value of people s assets Step 4: With higher interest rates and lower wealth, investment falls. It may raise the exchange rate of the currency, depressing net exports Step 5: Tight money leads to reduced aggregate demand, reduces income, output, jobs and inflation

In short
In a fully employed economy, the higher money supply would be chasing the same amount of output and would therefore mainly end up raising prices That is, in the long run, prices and wages are more flexible, and money supply changes tend to have a larger impact on prices and a smaller impact on output

Inflation and interest rate

If both lenders and borrowers expect inflation over the term of a loan . .
Lenders will demand a higher rate because the money repaid will have less purchasing power than the money they lend now Borrowers will willingly pay a higher rate because they know it will be easier to earn the needed money later than it is now

Videos
http://www.moneycontrol.com/video/economy/monet ary-tightening-may-not-help-tame-inflationecoadvisor_434618.html http://economictimes.indiatimes.com/Chetan-Ahyareviews-RBI-monetarypolicy/videoshow/5162691.cms http://economictimes.indiatimes.com/Need-tocoordinate-monetary-and-fiscal-policy-DSubbarao/videoshow/4893491.cms

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