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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)
Also:
M1: R 1253184 cr r
Curr c wi ublic Other deposits with the RBI 1%
, Marc 2009
D mand deposi s
46% 53%
12%
74%
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
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)
ii) Payment received from the central bank for sale iii) Payment received from abroad and deposited
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.
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
Secondary deposits
Central Government also issues money in the form of onerupee notes, coins and small coins (the share is negligible)
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.
That is, the total supply of money (Ms) depends on the supply of the high-power money (H) and the money multiplier (m)
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
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
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.
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
3. which increases the quantity of goods and services demanded at a given price level.
r1 r2
Aggregate demand, AD1 AD2
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
Money Supply
The money supply is controlled by the RBI through:
Changing Changing
Open-market
Thus the quantity of money supplied does not depend on the interest rate and is vertical.
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
Policy Rates
(www.rbi.org.in, 07/06/2010)
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)
6% 25 %
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
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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