PGP Presentation

Time: 75 Minutes
Slides: 26
MONEY DEMAND AND MONEY
SUPPY PROCESS

Session 10-11
MONEY DEMAND AND MONEY SUPPY PROCESS
(MONETARY POLICY)

Indian Institute of Management

Rohtak

Prof. Rupika Khanna

Area Chairperson
Economics and Public Policy Group

Southern by-pass, Sunaria, Rohtak – 124010, Haryana, India

Phone: +911262-228545 (O)
Email: rupika.khanna@iimrohtak.ac.in

Indian Institute of Management Rohtak

November, 2019
What is money?

?
Types of money
 Fiat money
 Legal tender money
 ‘Near money’

RK: MEP, SS10

Demand for and Supply of Money
Sources of money demand

Transaction demand: Mt = k(Y)

Precautionary demand: Mp = k(Y)
Speculative demand: Msp = h(r)
Md = L(Y, r)
Real balance equation
Md kY- hr
P
k , h >0

RK: MEP, SS10

Measurement and Components of Money Supply
1. Reserve Money (M0)

Currency in circulation

+ ‘other’ deposits with RBI

+ Bankers’ deposits with RBI

RK: MEP, SS10

Contd…
2. Narrow Money (M1)
Currency with the public
+ Current account deposits with banks
+ Traveler’s checks
+ Other checkable deposits

3. Broad Money (M3)

M1
+ savings deposits
+ time deposits with banks
+ money market mutual fund (these are checkable deposits!)

RK: MEP, SS10

The Income Velocity
 The income velocity of money is the number of times
the stock of money is turned over per year in financing
the annual flow of income
 Equal to the ratio of nominal GDP to the nominal money
stock:
P Y Y
V 
M M
P
 Can also be interpreted as the ratio of nominal income to
nominal money stock OR the ratio of real income to real
balances

RK: MEP, SS10

The Quantity Theory
 The quantity theory of money provides simple way to
think about the relation between money, prices, and
output:
M V  P  Y
 The equation is the famous quantity equation, linking
the price level and the level of output to the money
stock
 The quantity equation became the classical quantity
theory of money with it was argued that both V and Y
were fixed
 If both V and Y are fixed, it follows that the price
level is proportional to the money stock

RK: MEP, SS10

The Quantity Theory
 The classical quantity theory = theory of inflation
 The price level is proportional to the money stock:

V M
P
Y
 If V is constant, changes in the money supply translate into
proportional changes in nominal GDP

 With the classical case (vertical) supply function, Y is fixed,

and changes in money translate into changes in the overall
price level, P

RK: MEP, SS10

India’s GDP and Money Supply
Velocity Velocity
GDPMP M0 M1 M3 (M0) (M3) Multiplier M0/GDP
1950-51 104 15 20 24 6.96 4.42 1.57 14.36
1960-61 179 22 29 40 8.01 4.53 1.77 12.48
1970-71 476 48 74 110 9.88 4.32 2.29 10.12
1980-81 1496 195 234 558 7.69 2.68 2.87 13.00
1990-91 5862 878 929 2658 6.68 2.21 3.03 14.97
2000-01 21687 3033 3794 13132 7.15 1.65 4.33 13.99
2005-06 36934 5719 8264 27195 6.46 1.36 4.75 15.49
2009-10 64778 11557 14893 56027 5.61 1.16 4.85 17.84
2010-11 77841 13768 16383 65041 5.65 1.20 4.72 17.69
2011-12 90097 14263 17374 73848 6.32 1.22 5.18 15.83
2012-13 101133 15149 18975 83898 6.68 1.21 5.54 14.98
2013-14 113551 17327 20547 94973 6.55 1.20 5.48 15.26
RK: MEP, SS10
Current Price in ₹billion GDP/M0 GDP/M3 M3/M0 M0/GDP
Calculating the Velocity of Money
Measuring the:
 Money supply (M) with M1,
 Price level (P) with the GDP deflator, and
 Level of real output (Y) with real GDP, so P×Y is nominal GDP,
We obtain the following value for velocity (V) in 2016:

$18.6 trillion
V  5.8
$3.2 trillion
We can always calculate V. But will we always get the same answer?
The quantity theory of money asserts that, subject to measurement
error, we will:
 Quantity theory of money: A theory about the connection
between money and prices that assumes that the velocity of
money is constant.
RK: MEP, SS10
The Quantity Theory Explanation of Inflation
When variables are multiplied together in an equation, we can form
the same equation with their growth rates added together.
So the quantity equation:
M×V=P×Y
generates:
Growth rate of the money supply + Growth rate of velocity
= Growth rate of the price level (or the inflation rate)
+ Growth rate of real output
Rearranging this to make the inflation rate the subject, and assuming
that the velocity of money is constant, we obtain:
Inflation rate = Growth rate of the money supply − Growth rate of
real output

RK: MEP, SS10

Money Stock Determination
 Now, let us understand the process by which the money supply
is determined and the role of the central bank
 The key concept is fractional reserve banking
 If only gold coins were money and only the king reserved the
right to mint coins, money supply would equal the number of
coins minted
 In the (futuristic) cashless society of today, the banks holds
gold coins equal to 20% of their outstanding deposits (here’s
where the fractional reserve banking part comes in)
 Let’s spend some time in developing the details of money
supply
Money Stock Determination
 High powered money (or monetary base) consists of
currency (notes and coins) and bank’s deposits at the RBI
 The Fed has direct control over high powered money (H)
 Money supply (M) is linked to H via the money multiplier, mm
 Money multiplier (mm) is the ratio of the stock of money to the
stock of high powered money i.e. mm > 1
 The larger deposits are, as a fraction of M, the larger the
multiplier
Money Stock Determination
 Money supply consists of currency, CU, plus deposits:
M  CU  D
 High powered money consists of currency plus reserves:
H  CU  reserves

 The behavior of the public, the banks, and the Fed in the
money supply process can be summarized by three variables:

 Currency-deposit ratio: cu  CU
D

 Reserve ratio: re  reserves D

 Stock of high powered money: H

RK: MEP, SS10

Money Stock Determination
 We can rewrite money supply as

M  (cu  1) D H  (cu  re) D

 This allows us to express the money supply in terms of its

principal determinants, re, cu and H:
1  cu
M H  mm  H
re  cu
where mm is the money multiplier given by:
1  cu
mm 
re  cu

RK: MEP, SS10

Money Stock Determination
 Some observations of the money multiplier:
1  cu
mm 
re  cu

 The money multiplier is larger the smaller the reserve

ratio, re
 The money multiplier is larger the smaller the currency-
deposit ratio, cu
 Smaller the cu, smaller is the proportion of H that is being
used as currency AND the larger the proportion that is
available to be reserves

RK: MEP, SS10

The Currency Deposit Ratio
 The payment habits of the public determine how much
currency is held relative to deposits
 The currency deposit ratio is affected by the cost and
convenience of obtaining cash
 Currency deposit ratio falls with ‘shoe-leather-costs’
 Ex. If there is a cash machine nearby, individuals will on
average carry less cash with them because the costs of
running out are lower
 The currency deposit ratio has a strong seasonal pattern
(highest around Christmas in United States)

RK: MEP, SS10

The Reserve Ratio
 Bank reserves = deposits banks hold at the Fed and
“vault cash” (notes and coins held by banks)
 In the absence of regulation, banks would hold reserves
to meet:
1. The demands of their customers for cash
2. Payments their customers make by checks that are
deposited in other banks
 In the U.S. (also in India), banks hold reserves primarily
because the central bank requires them to (required
reserves)
 In addition to required reserves, banks hold excess
reserves to meet unexpected withdrawals

RK: MEP, SS10

The Reserve Ratio
 Fed began paying interest on required and excess reserves
during Great Recession
 During Great Recession, excess reserves in United States grew
as banks made fewer loans which had a significant impact on
the money multiplier

RK: MEP, SS10

Credit Creation
 Now let us understand factional reserve banking and credit
creation by commercial banks

 Mr. A has Rs. 1000 in the form of currency

 He deposits Rs. 1000 in a bank

 The deposits that the bank has received but not yet lent out
are called reserves because of the assumption that if the entire
money is held as deposit and no loans are made, it will not
affect the money supply (100 percent reserve banking)

Balance Sheet of Bank

Assets Liabilities
Reserves 1000 Deposits 1000

RK: MEP, SS10

Credit Creation
If the bank uses the deposit to make loans:

 The bank after keeping a certain fraction of deposit money as

reserve (called reserve ratio) lends the rest, it is called
fractional-reserve banking

 Banks keep reserves so that these are available when

depositors make withdrawals

 The bank keeping a reserve of 20% lends the rest to Mr. B

New balance Sheet of Bank A

Assets Liabilities
Reserves 200 Deposits 1000
Loans 800

RK: MEP, SS10

Credit Creation
 Money supply increases by Rs. 800 when the bank makes the
loan

 Money supply
o Before the loan was made: Rs. 1000
o After the loan is made: Rs. 1800

 Thus banks create money/ credit

 But the process of credit creation does not stop here. If Mr. B
deposits Rs. 800 in Bank B, then the process continues

Balance Sheet of Bank B

Assets Liabilities
Reserves 800 Deposits 800

RK: MEP, SS10

Credit Creation
 Bank B after keeping a reserve ratio of 20 % lends to Mr. C
New balance Sheet of Bank B
Assets Liabilities
Reserves 160 Deposits 800
Loans 640

 Thus Bank B creates money equal to Rs. 640

 Total money supply has increased to Rs. 2440 (Rs. 1800 of

Bank A + Rs. 640 of Bank B)

 The process goes on and on. With each deposit and loan, more
money is created
RK: MEP, SS10
Credit Creation
 Total money supply = [1+(1-rr) + (1-rr)2 + (1-rr)3…….] * Rs.
1000

 This is a geometric progression series:

 Deposit multiplier = 1000 *1/ (1-(1-rr)

= 1/0.20 * 1000
= Rs. 5000

RK: MEP, SS10

How does RBI influence money supply
(Monetary Policy)
Open Market operations (including
Repo & Reverse Repo)
INSTRUMENTS Marginal Standing Facility (MSF)
Bank Rate
Statutory Reserve Requirements (CRR)
Secondary Reserves (SLR)
RBI’s Credit to Development Banks
INTERMEDIATE Moral Suasion
TARGET
Exchange Rate
Money Supply
Interest Rate

ULTIMATE Stable Prices

OBJECTIVES Low Unemployment
Rapid Growth of GDP
RK: MEP, SS10
The Monetary Transmission Mechanism

AD>AS, Inflation

Contraction in Money Supply

Higher Interest Rate

Fall in investment etc.

AD, Y and Prices fall

RK: MEP, SS10