The Monetary

System

The Supply and Demand of Money

What is Money?
• Money-> the set of assets in an economy that people
regularly use to buy goods and services from other
people.

- ‘Money is anything that is generally acceptable by the

people as a means of payment in the final settlement
of all transactions including debts’.

• Wealth-> the total collection of pieces of property that

serve to store value (stock)

• Income->flow of earnings per unit of time (flow)

 The Functions of Money
• “Anything that satisfies the four important function of it,

A Medium Of Exchange is anything that is readily acceptable as payment for buying and
selling goods and services.

A Unit Of Account is the yardstick people use to post prices and record debts.

A Differed Payment: Payment in future

A Store Of Value is an item that people can use to transfer purchasing power
from the present to the future.

Money is the most liquid assets .

Liquidity is the ease with which an asset can be converted
into the economy’s medium of exchange.
 Developments and Kinds of Money
Type Definition Example

Barter System: Goods were exchanged against goods. Corn vs. Rice

Commodity Money which has intrinsic value. Ex. Salt, grains, feathers, cowry
Money: shells, beads and even fish hooks
Representative Consists of token coins, other physical tokens. Gold, silver, oil, bank check
Money: It is backed by 100% precious metal.
Credit Money: Any future monetary claim against an individual Ex. IOUs, bonds, money market
that can be used for the purchase of goods and accounts, and any other form of
services. financial instruments.
Fiat Money: Is a money by declaration. Its the value of 1. Coins: not full bodied money but
determined by legal means (legal tender) ex. Notes token money (intrinsic value<face
value)
of RBI. 2. Currency notes: not full-bodied
money
3. Demand deposits (withdrawable
through cheque)

Electronic Money transfer through electronic media. Debit card, credit card, efts, wire
Money: transfers
Developments and Kinds of Money
Money Supply
 The Supply of Money
❖ Who Supplies?
By public we refer to the
a) Reserve Bank of India, : Paper Notes
households, firms, local
b) Central Government of India : Coins
c) Commercial and Cooperative authorities, companies etc.
Banks ( Banking System) : Credit

❖ Money Stock: All the money held with the Reserve Bank of India (RBI), the
Government as well as the Public is called the total stock of money.

❖ Money Supply:
o Means that part of the total stock of money (paper notes, coins and demand
deposits of bank) in circulation which is held by the public.
o at any particular point of time for spending purpose.
o Generally fixed during a given year. Ex 31 Aug. 2019
o The stock of money held by government and the banking system are not
included in Money Supply
o because they are suppliers or producers of money and cash balances held by
them are not in actual circulation.
o Money supply includes currency held by public only for spending ( transaction)
purpose and net demand deposits in banks.
 Supply of Money: Dimensions
Too little value of the lower denominations
 Supply of Money
How much to Print & Mint
❑ Replacement needs ( old worn and tear one)

❑ Incremental needs ( Demand for money: GDP growth

rate, inflation rate , interest rate etc.)

❑ Reserve Stock Requirement Needs

(CRR, SLR, Gold reserve, Forex reserve)

• Assess the stock on daily basis

• Uses statistical analysis and long-term forecast
• Printing/minting allocated between the presses/mints
and delivery schedule decided in advance
• Uses some Statistical models
 Supply of Money
Network of Currency Chests
• RBI has offices at 31 locations and 19 issue offices for currency
operations across India

• Distribution of notes and coins throughout the country is done through

designated bank branches, called chests.

• RBI has authorized selected branches of scheduled banks to establish

currency chest.
• Chest is a repository in a commercial bank to store notes and coins on
behalf of the Reserve Bank
• Deposit into chest leads to credit of the commercial bank’s account and
withdrawal is debit

As of June 30, 2006 there were 4428 currency chests and 4102 small coins depots.
As of Dec 31, 2017 there were 4034 currency chests and 3707 small coins depots.
 Supply of Money
Currency Chest: Role
• Meets currency requirement of
public.
• Exchange facility from one
denomination to another
• Payment requirement of the Govt.
• Exchange of damaged notes and
withdraws unfit notes
• Avoids frequent movement of
cash
• Chest branch operates with
minimum cash balance (Rs.
1,00,000)
Currency Chest :Mechanism
• Net deposit /withdrawal of notes
and coins at the chest is reported
on daily basis to parent Issue
Office or else penalty.
• Overall deposit or withdrawal
leads to credit or debit of bank’s
account in RBI
• Net withdrawal from chests means
expansion of currency and
deposits means contraction
• Notes in circulation being the
liability of RBI, it adjusts its asset-
liability position centrally for such
expansion or contraction
RBI’s Empirical Definition & Estimation of
Money Supply

What assets
should be
considered part of
the money
supply?
 RBI or Empirical Definition of Money:

1. The First Working Group on Money Supply

(FWG) (1961), Chairman: Dr S L N Simha

2. The Second Working Group on Money Suppy

(SWG) (1977) Chairman: Shri M L Ghosh

3. The Third “Working Group on Money Supply:

Analytics and Methodology of Compilation”
(WGMS) (1998) Chairman: Dr. Y.V. Reddy

https://www.investopedia.com/terms/m/moneysupply.asp
 RBI or Empirical Definition of Money: Components

More Liquid Less Liquid

Cash Demand Fixed Post Office Certificate Securities Physical

Deposits Deposits Deposits of Deposits /Bonds Assets, land
of Banks Buildings, etc.

Medium of
Exchange Store of Value Functions
Functions

Narrow Money (M1) Broad Money (M3)

 RBI or Empirical Definition of Money:
M0 (Reserve Money), M1(narrow money), M2, M3(broad money)

M0 = Currency in circulation + Banker's deposit with RBI+

Other deposits with RBI

M1 = Currency with the public + Demand deposits with the banking

system + ‘Other’ deposits with the RBI.

M2 = M1 + Savings deposits of post office savings banks

M3 = M1+ Time deposits with the banking system

M4 = M3 + Post office savings banks (excluding NSC).

Other deposits with RBI= (i) deposits of quasi govt and other financial institutions such as Primary Dealers' balances in the
accounts of foreign centrals banks and govts (iii)accounts of IMF, (iv) provident funds, gratuity and guarantee funds of RBI staff.
 RBI or Empirical Definition of Money:
M0 (Reserve Money), M1(narrow money), M2, M3(broad money)

Total notes issued = Notes in circulation + Notes held in Banking

Department of RBI.
Note in Circulation= Note issued by GOI since 1935 and RBI -notes
held by banking Dept of RBI

OR
Note in Circulation= = currency held outside RBI by the public , banks
treasuries etc.

OR Currency in circulation = Note in Circulation , rupee coins and small

coins.

OR Currency in circulation = Currency with public +cash in hand of

banks.

Currency with public = Currency in circulation - cash in hand of banks.

 RBI or Empirical Definition of Money:
M0 (Reserve Money),
Measures M1(narrow
of Monetary andmoney), M2, M3(broad
Liquidity money)
Aggregates

New Monetary Aggregates

 RBI or Empirical Definition of Money:
Money Supply and Monetary Aggregates:

➢ All the money held with Public, RBI as well as Government is called Total Stock
of Money.
➢ Money Supply is that part of this Total Stock of Money which is with public.
➢ By public we refer to the households, firms, local authorities, companies
etc.
➢ Thus, public money does not include the money held by the government
and the money held as CRR with RBI and SLR with themselves by
commercial banks.
➢ The reason of excluding the above two categories from money supply is
that this money held by the Government and RBI is out of circulation.
➢ In other way, this money has two components viz. Currency Component and
Deposit Component.
➢ Currency Component consist of all the coins and notes in the circulation,
➢ Deposit Component is the money of the general public with the banks,
which can be withdrawn by them using cheques, withdrawals and ATMs.
➢ Deposit can be either Demand Deposit or Time Deposit
 RBI or Empirical Definition of Money:
Measures of Monetary and Liquidity Aggregates

Primary dealer is a formal designation of a firm as a market maker of government securities

 RBI or Empirical Definition of Money:
Components of Money Supply (Rupees crore)
 RBI or Empirical Definition of Money:
A Stylized Decomposition RBI’s Balance Sheet(for Reserve Money)
Liabilities Assets
1. Currency in Circulation(of which) 1. Loans and Advances ( of which)
i. Currency with the Public i. Govt: Centre and State
ii. Cash in hand of Banks ii. Banks: commercial and cooperative
iii. Commercial Sector ( NABARD,
2. Bank’s Deposits (CRR, SLR) other FIs)

3. Govt. Deposits: All Govt. 2. Investment ( of which)

4. Paid-up Capital:
(Ex. shareholders capital)
5. Reserves :
( Ex. contingency + revaluation
reserves out of retained profit)
6. Other Liabilities
(Ex. EPF, NBFIs deposits)
Total Liabilities (1 to 6)
i. Govt. Securities
ii. Foreign Assets(Net)
3. Gold ( Monetary)
4. Other Assets ( land, building etc.)
Total Assets (1 to 4)
 RBI or Empirical Definition of Money:
Rearrange RBI’s Balance Sheet: (for Reserve Money)
Liabilities Assets
1. Monetary Liabilities 1. Net Central Bank Credit to Government (i+ii)
(i+ii) i. loans and advances to Govt
i. Currency with the ii. Investment in Govt. Securities)
public 2. Central Bank Credit to Banks
ii. Bank reserves commercial banks at bank rate, repo rate etc.
3. Central Bank Credit to Commercial Sector (OFIs,
2. Non-Monetary NABARD) (i+ii)
Liabilities (i+ii+iii) i. loans and advances to other financial institutions
i. Paid-up Capital
ii. Investment on securities of commercial sectors
ii. Reserves
iii. Govt Deposits 4. Net Foreign Assets of Central Bank (i+ii)
i. Investment in Foreign Assets
3. Other Liabilities ii. Gold ( Monetary)

5. Other Assets
Total Liabilities (1+2+3) Total Assets (1+2+3+4+5)
 RBI or Empirical Definition of Money:
A Stylized Decomposition of Reserve Money

Reserve Money (M0) =1+2+3-4

 RBI or Empirical Definition of Money:
Sources of Changes in Reserve(M0) and High Powered (H) Money

1. Net Central Bank Credit to Government (i+ii-iii)

i. loans and advances to Govt
ii. Investment in Govt. Securities
ii.. Govt Deposits with central bank
2. Central Bank Credit to Banks
commercial banks at bank rate, repo rate etc.
3. Central Bank Credit to Commercial Sector (OFIs, NABARD) (i+ii)
i. loans and advances to other financial institutions
ii. Investment on securities of commercial sectors High Powered Money=
4. Net Foreign Assets of Central Bank (i+ii)
Reserve Money + Govt’s Currency
i. Investment in Foreign Assets
Liabilities to the Public
ii. Gold ( Monetary)
5. Government's Currencies Liabilities to the Public H=M0+GCL
i. Rupee Coins and small coins
6. Net Non-Monetary Liabilities of the Central bank (i+ii+iii-iv)
i. Reserves, ii. Paid up reserves, iii. other liabilities , iv. Other assets etc.
Reserve Money (M0) =1+2+3+4-6
High Powered Money(H) =1+2+3+4+5-6
 RBI or Empirical Definition of Money:
Sources of Changes in Reserve Money(M0) (Rupees Billion)

Net
Net RBI Net RBI Net Governme
RBI Credit RBI''s Non-
Credit to Credit to Foreign nt's
to Gross monetar Reserve Money
Year Central State Exchange Currency
Commerci Claims on y (M0)
Governme Governme Assets of Liabilities
al Sector Banks Liabilitie
nt nts the RBI to Public
s of RBI
0 1 2 3 4 5 6 7 1+2+3+4+5+6-7

1970-71 36.67 3.33 1.32 5.30 3.84 6.42 8.66 48.22

1980-81 152.78 11.65 17.00 47.75 6.18 12.76 53.60 194.52

1990-91 867.58 20.90 63.42 79.83 16.21 100.07 270.22 877.79

2000-01 1465.34 73.43 132.87 1971.87 53.54 129.65 793.74 3032.95

2009-10 2115.81 0.05 13.28 12319.44 112.70 11.69 3016.43 11556.53

2010-11 3940.35 25.20 21.64 13285.69 127.24 51.59 3683.50 13768.21

2011-12 5344.13 13.24 39.60 14721.95 134.44 48.47 6038.41 14263.44

2012-13 5904.99 0.79 30.58 15580.59 153.40 403.54 6925.02 15148.86

 RBI or Empirical Definition of Money:
Sources of Changes in Broad Money Supply (M3)
1. Net Bank Credit to Government (a+b)
a. Central bank Net Credit to Govt (i-ii)
i. Centrak banks credit to Government
ii. Govt Deposits with central bank
b. Other Bank’s credit to Government
2. Bank Credit to Commercial Sector (a+b)
a. Central bank Credit to Commercial Sector
b. Other bank’s Credit to Commercial Sector
3. Net Foreign Exchange Assets of Banking Sector(a+b)
a. Central bank’s Net Foreign Exchange Assets
b. Other bank’s net foreign exchange assets
4. Government's Currencies Liabilities to the Public
a. Rupee Coins and small coins
5. Net Monetary Liabilities of the Banking Sector(a+b)
a. Net Monetary Liabilities of the Central bank
b. Net Non-Monetary liabilities of Banks
Ex. (i). Reserves, (ii) Paid up reserves, (iii) other liabilities etc.
Broad Money Supply(M3) =1+2+3+4-5
Role of Bank and Money Supply
 Banks and the Money Supply: An Example

Suppose Rs.100 of currency is in circulation. To determine

banks’ impact on money supply, we calculate the money
supply in 3 different cases:

1. No banking system
2. 100% reserve banking system:
banks hold 100% of deposits as reserves,
make no loans
3. Fractional reserve banking system
Banks and the Money Supply: An Example

CASE 1: No banking system

Public holds the Rs.100 as currency.

Money Supply = Rs.100.

 Banks and the Money Supply: An Example

CASE 2: 100% reserve banking system

Public deposits the Rs.100 at Punjab National Bank (PNB).

PNB holds PUNJAB NATIONAL BANK

100% of Assets Liabilities
deposit Reserves Rs.100 Deposits Rs.100
as reserves:
Loans Rs. 0

Money supply
= currency + deposits = Rs.0 + Rs.100 = Rs.100
In a 100% reserve banking system,
banks do not affect size of money supply.
 Credit Creation
CASE 3: Fractional Reserve Banking System
Credit Creation
Credit Creation
Credit Creation
Credit Creation
Credit Creation
Credit Creation
Credit Creation
 Credit Creation
High Powered Money, Money Multiplier and Money Supply

Where,
Where, • M (or M3)= Money Supply
• C= Currency • H( or Mo)= High Powered Money
• D= Deposits • Cr= Currency to Deposit Ratio
• DD= Demand Deposit • RRr= RR/D = Required Reserve Ratio
• TD= Time Deposit • ERr=ER/D= Excess Reserve Ratio
• RR= Required Reserve • m= Money Multiplier
• ER= Excess Reserve
 Credit Creation: Example-1

• If the required reserve ratio is RRr=10 percent, currency in

circulation (C) is Rs 400 billion, checkable deposits (D) are
Rs. 800 billion, and excess reserves (ER ) total Rs. 0.8
billion,
• What’s the Money Supply, Monetary Base and Money
Multiplier?
• Cr = C/D = 400/800 = 0.5;
• ER= 0.8 => ERr = ER/D = 0.8/800 = 0.001;
• RRr = RR/D= 0.1,=> RR=0.1*800=80 billion
• m =(1+Cr)/Cr+ERr+RRr) = 1.5/0.601 = 2.49584
• Monetary Base(or H) =C+ R=480.80 , R=ER+RR
• Monetary Supply (M3) = C + D = 400+800 = Rs1200 billion
• Can check: M = m * H = m * (C+R) =
2.49584*(400+0.8+0.1*800) = Rs.1200 billion
 Credit Creation: Factors that Determine
the Money Multiplier

• Changes in the currency ratio Cr

– The money multiplier and the money supply are
negatively related to Cr
• Changes in the required reserve ratio RRr
– The money multiplier and the money supply are
negatively related to RRr
• Changes in the excess reserves ratio ERr
– The money multiplier and the money supply are
negatively related to the excess reserves ratio ERr
 Credit Creation: Factors that Determine
the Money Multiplier
Changes in the Currency Ratio (Cr)
Factors that cause Cr to change.
– Changes in income/wealth
• Larger proportions of currency are held by people with
low income/wealth
• As income/wealth rises, the ratio of currency to
deposits falls

– Changes in expected returns

• As the interest rate on deposits rises, Cr falls
• As the cost of acquiring currency falls, Cr rises
• Fears of bank insolvency (i.e. bank panics) cause Cr to
rise sharply
• Increases in illegal activity cause Cr to rise
 Credit Creation: Factors that Determine
the Money Multiplier
Changes in the Excess Reserve Ratio (ERr)
• What are the costs and benefits to banks of holding excess reserves?

• Market Interest Rates (-)

– The opportunity cost of an excess reserve is interest rate earned
forgone. As market interest rates rise, this opportunity costs
increases and banks hold fewer excess reserves
– ERr is negatively related to market interest rates

• Expected Deposit Outflows (+)

– The main benefit of holding excess reserves is that they insulate
the bank (somewhat) from sudden deposit outflows. With excess
reserves, banks do not have to call in loans, sell off other assets, or
borrow from the RBI to cover deposits being withdrawn
– If banks think that deposit outflows will increase, they would be
wise to increase their excess reserve ratio
– ERr is positively related to expected deposit outflows.
 Credit Creation: Factors that Determine
the Money Multiplier
Changes in the Required Reserve Ratio (RRr)
• RBI can increase/decrease the money supply by
lowering/raising the reserve ratio (RRr) i.e. CRR and SLR.

– By increasing or decreasing the CRR and SLR RBI can

influence Money Supply.
– Banks have found that they need to keep extra currency
in ATM’s over weekends and holidays. This currency is
classified as vault cash and counts toward required
reserves

• If RRr is not binding, then any change in RRr will have little
to no effect. (only works if you significantly increase RRr!)
Factors affecting Money supply: Summary

• Bank credit

• Deficit financing

• Foreign exchange reserves

• Government Expenditure

• FII inflows
Demand for Money
 Demand for Money

What is Demand for money?

– Demand for money means the willingness and ability to

have money at a specific price at a point of time.

What determines demand for Money??????

– Different schools of thought

• Classical Economists
• Keynesian Economists
• Post Keynesian
– Baumol and Tobin
• Monetarist Economists

Origin of Demand for Money:

is the Quantity Theory of Money(QTM)
1.Classical Theory of Money and Interest
1568 by Jean Bodin, French Philosopher
1911 by Irving Fisher: Most popular and represents
classical theory

A) Fishers (1911) Quantity Theory of Money and Price Level :

MV = Σpiqi …..…….(1) Original Classical Economists:

MV = PT ………….(2) Fisher Version money is demanded for
where transaction purpose
• M = quantity of money in circulation
• V = transaction velocity of circulation of money i.e. no of times money
used to purchase output
• pi= price of each output, qi = real output
• P = weighted average price level or general price level
• T= Sum of all transactions of goods and services per unit time

If we Include Money Supply created by banks though DD, than eq become

• MV+M’V’=PT (3)
1.Classical Theory of Money and Interest

a. QTM as Theory of Price Level: P=(MV+M’V’)/T

b. QTM as Theory of Demand for Money: MS= Md

MV = PT ..........QTM : FisherVersion Given Money Supply
1
= M = PT Here M denotes Money Supply
V
ForEqilibrium : M s = M d , and , M s = M s
1
= M d = PT
V
1 •Md/P is the real cash balance
= M d = kPT .........(6), where, k =
V
•People need money to buy goods
or , M d = kY ,............(7) and services.
where; Y = PT
•So money is demanded for
or , M d / P = ky
transaction purpose and it depends
So, M d = f (Y )............(8) upon level of income
1.Classical Theory of Money and Interest
Velocity of Circulation of Money

• There has been a secular decline in the velocity in the post-independence era reflecting
monetization ( maybe due to NAREGA)and commercialization of the economy.

• The income velocity of money is stable in short run in recent years.

• The decline in velocity accelerated in the aftermath of the global economic crisis reflecting the
weakness in credit demand and preference for liquidity
2. Keynesian Theory of Money and Interest
Keynesian Theory of Demand for Money
People hold money in two alternative form
1. Cash/Currency
2. Bonds or Securities,

_
P is fixed in entire Keynesian Models
2. Keynesian Theory of Money and Interest
Keynesian Theory of Demand for Money
MdT=f(Y) Transaction and Precautionary demand for
and MdP=f(Y) money is interest inelastic.
So, MdT=k(Y) k>0
and MdP=k(Y) k>0
k is constant proportion of money demand from Income for transaction
purpose in transaction demand for money and also the same in
precautionary demand for money.

MT d
Md

Y Y
Qty of money demand for transaction
Total Money Demand: Md=MTd+Mpd and precautionary purpose
=>Md=kY…………………(11)
2. Keynesian Theory of Money and Interest
Keynesian Theory of Demand for Money
Speculative Demand for Money
MdSp=f(i) i>0 and ΔMdsp/ Δi<0
=> Mdsp=Lo-h*I Speculative demand for money
h is constant proportion of money demand from interest rates

If : i < i1 –>Wealth holders will hold money only.

If : i > i1 –> Wealth holders will hold bonds and the
speculative demand for money will be zero.
e
If : i = i1 –> Wealth holders will be indifferent between
money and bonds. Mspd demand curve is perfectly elastic

• In th United States and Europe in 2008–

2010, as short-term policy rates for the
various central banks moved close to zero.

• Many developed world during 2008-11

including US, Japan and Europe were
under liquidity trap
2. Keynesian Theory of Money and Interest
Keynesian Theory of Demand for Money
Total Demand for Money: Sum of all these demand functions
We know, MdT&P=f(Y)
MdSp=f(i) i>0 and ΔMdsp/ Δi<0
=> Md=MdT+Mdp+Mdsp)
 Md=kY+L0-hi
 So, Md=f(Y,i)

Real money demand depends upon real output and overall interest rates.
 References:
• Handout supplied to you on Money:
Demand and Supply

• Ch 4 and 25, Macroeconomics by

Blanchard
• Ch 8, Macroeconomics by NG Mankiw and
MP Taylor( your textbook)
Thank You All