Demand for

Money,
Supply of Money
and Monetary
Policy
Dr. Shylajan, C.S

Topics of Discussion

Money Supply
Money Stock Measures
The Money Market: DD & SS
The Demand for Money: Keynesian
Theory
Determination of Interest Rates
Monitory Transmission Mechanism
(Change in Monetary Policy and Impacts
on Interest Rate, Consumption,
Investment, AD and GDP)
Nominal Vs Real Interest Rates

Money Supply-How
is it defined

Money is a medium of exchange.

It is what we use to make
payments
What is that we use to make
payments?
Currency and
Chequeable deposits with banks

Components of
Money Supply

Narrow Money (M1)

Broad Money (M3)
M1 = Currency with public + saving
(demand) deposits with banks + other
deposist with RBI
M3 = M1 + time (fixed) deposits with
banks
Currency with Public= Currency in
circulation - cash with banks

Money Stock
Measures (in India)

Example:

(a) Currency with public = 486,679 crores

(b) Demand/Saving Deposits =435,163 cr

( C) Other deposits with the RBI = 5,768

cr
M1 = (a + b + c) = 927,610 Cr

(d) Time deposits (Fixed Dep) = 2,548,475

cr

M3 =3,476,084 Crores

Why do we Demand
Money

What we mean by demand for

money?

Demand is mainly for 3 reasons

Transaction demand for money
Precautionary demand for
money
Speculative Demand for Money

Why do we Demand
Money
Transaction demand for money

Positive function of income

Negative function of interest rate

Precautionary demand for money

Positive function of income

Negative function of interest rate

Why do we Demand
Money

Speculative Demand for Money

Expected change in interest rates

In short, demand for money is a

negative function of interest rate and
positive function of income

Stability of demand for money is the

key to proper conduct of monetary
policy (for example , instability of now)

The Money Market and

Determination of
Equilibrium Rate of Interest

Interest rate: cost of borrowing money

How does the interest rate determined?

Supply of money and demand for money (in a

market driven, not so regulated mechanism)

Interest rate is set by the intersection of DD

for and SS of money

Determination of
Interest RateGraphically
Demand for money is inversely
related to interest rate

Supply of money is given

(determined by Monetary
authority, RBI for instance)

Interest Rates

Consumers and investors rely on

money for purchase of goods and
services.

Monetary authority can augment AD

or reduce AD by changing money
supply and thereby interest
rates.

Change in Monetary
Policy

Monetary authority may follow a

Easy monetary policy or

Tight monetary policy

What is easy and tight monetary policy?

Easy Monetary Policy money supply

growth increases..interest rate decline
How does money supply growth increases?
(cut in CRR, for instance)

Change in Monetary
Policy

Then what happens to demand for

money?

Demand for money will increase and

Then spending on goods and

services increases (for instance
consumer spending and investment
spending)

Change in Monetary
Policy

Tight Monetary Policy..money supply

growth falls..interest rate increases

Then demand for money will fall..so

spending on goods and services falls

What kind of monetary policy RBI is

following now? (By decreasing CRR)

Change in Monetary
Policy and Impacts Graphically

Nominal Vs Real
Interest Rates

Real interest rate = Nominal

interest rate minus rate of
inflation

12% nominal interest rate 10%

inflation rate =2% real interest
rate

The Money Supply

Process

What causes change in money supply?

M=C+D
Where M is money stock, C is currency
with public and D is bank deposits
Three groups influence money supply
growth
1. Central bank
2.Commercial Bank
3. Public

Money Multiplier

Money multiplier (m) = M3/H

M3 = C+DD+TD
High powered money = Currency + Reserves
The total demand for high-powered money
comes from the public, who wants to use it
as currency, and the banks, which need it as
reserves
Where m is money multiplier
M3 is total money supply

Control of Money
Supply by RBI
Instruments of Control
Changing Reserve Requirements
(CRR, for instance)
Changing the Bank Rate
Direct Credit Controls

Monetary Policy
Transmission
Mechanism
Money supply change
Effect

on interest rate r
Impact on business spending
Impact on consumer spending
Impact on Output or GDP

Monetary Policy in
the AD- AS
Framework
Two Cases

Case 1:The case of increase in AD

where potential output is not achieved

Case 2: The case of increase in AD and

its impact on output and price when
potential output is reached

Graphical approach

Monetary Policy in
India

Changes in major Monetary Policy

Measures:

Bank Rate
Cash Reserve Ratio (CRR)
Statutory Liquidity Ratio (SLR)

Monetary Policy in
India

Bank Rate in 1999:

12 %
In 2003 :
6%
In 2007 &2008
:
6%
CRR in 1991 :
15 %
In 2004 :
5%
In 2007 :
7.50%
In 2008 Nov :
5.5%
SLR in 1992 :
38.5 %
In 1997 :
25 %
In 2007 :
25 %
In 2008 Nov :
24%

Summary