Chapter 4

The supply of money

Learning outcomes
Describe and discuss the different roles of financial
intermediaries.
Describe why maturity transformation is so important in
financial markets.
Define on which side of a bank's balance sheet deposits
and loans appear and
Explain why the balance sheet must indeed balance.
Explain how the monetary authorities can influence the
total money supply by changing the monetary base or by
introducing mandatory reserve ratios or other Regulation.

Essential reading
Artis, M.J. and M.K. Lewis Money in Britain:
Monetary policy, innovation and Europe.
(New York; London: Philip Allan, 1991).
Goodhart, C.A.E. Money, Information and
Uncertainty. (London: Macmillan, 1989)
Chapters 5, 6 and 10.
McCallum, B. Monetary Economics. (New
York;
Macmillan;
London:
Collier
Macmillan, 1989).

Financial intermediaries
Financial intermediaries, such as banks,
are hugely important in activities such
as the financing of investment projects
and in the safekeeping of savings.
The main service is the collection of
funds from those who wish to save and
the lending out of funds to those who
wish to borrow.

 The reward for providing such

services comes from the difference
between the rate of interest paid on
savings and that charged on loans.

Question
If there are agents who want to save
and others who want to borrow,
why do those with funds to spare not
just lend directly to those who want to
borrow?

REASONS FOR EXISTENCE OF

FINANCIAL INTERMEDIARIES
Economies of
information.

scale

in

transactions

and

Agents with funds to save should hold a large number

of different assets (diversified portfolio) but have
limited funds available.
If an agent wanted to borrow a large sum of money,
to buy a house or factory it is unlikely that they would
find a single other agent willing to lend such a large
sum.
The financial intermediary may also be able to obtain
better information about the creditworthiness of a
prospective borrower

 Insurance:
Agents are, in general, risk-averse.
Banks provide insurance services by
guaranteeing a rate of return to depositors
even if loans made to borrowers turn bad.
Without the bank, the default risk would be
faced entirely by the individual/depositor.

 Maturity transformation:
Individual lenders generally want to lend (to the bank)
while still having quick access to their money, in order
to make transactions or for precautionary motives.
The liabilities of the bank (the deposits of savers) are
then liquid and the bank will promise to convert the
depositors assets on demand.
The banks assets, on the other hand, will tend to be
illiquid since private borrowers tend to want to hold
long maturity liabilities (the loans/assets of the bank).

RBI Measures of Money

Supply
The Reserve Bank of India has a long
tradition of compilation and dissemination
of monetary statistics, since July 1935.
In view of the ongoing changes in the
Indian
economy
as
well
as
the
developments in monetary sector,
Working groups were set up periodically to
review
and
refine
the
monetary
aggregates.

Three working groups

The First Working Group on Money Supply
(FWG) (1961),
The Second Working Group (SWG) (1977)
and
The Working Group on Money Supply:
Analytics and Methodology of Compilation
(WGMS) (Chairman: Dr. Y.V. Reddy) (1998).

CONCEPTS AND
DEFINITIONS
Reserve
Money
=
Currency
in
circulation + Bankers deposits with
the RBI + Other deposits with the
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 + All deposits with post
office savings banks (excluding
National Savings Certificates).

New Monetary Aggregates

NM1 = Currency with the public +
Demand deposits with the banking
system + Other deposits with the RBI.
NM2 = NM1 + Short-term time deposits of
residents (including and up to the
contractual maturity of one year).
NM3 = NM2 + Long-term time deposits of
residents + Call/Term funding from
financial institutions.

Liquidity Aggregates
L1 = NM3 + All deposits with the post
office savings banks (excluding National
Savings Certificates).
L2 = L1 +Term deposits with term lending
institutions and refinancing institutions
(FIs) + Term borrowing by FIs +
Certificates of deposit issued by FIs.
L3 = L2 + Public deposits of nonbanking
financial companies.

BALANCE SHEET OF
COMMERCIAL BANKS
LIABILITIES

ASSETS

1) Share Capital (paid up)

1) Cash Balances
a) With Central Bank
b) With other Banks

2) Reserves and surplus

2) Money at call and short notice.

3) Deposits :a) Time deposits.

3) Bills discounted, including treasury bills.

b) Demand Deposits
c) Saving Deposits
4) Borrowings

4) Investments

5) Other Liabilities

5) Loans and Advances

6) Other Assets.

Liabilities
Capital: The bank has
commencing its business.

to

Reserve Fund: Reserve fund

undistributed profits of the bank.

raise
is

capital

the

before

accumulated

Deposits: The deposits of the public like demand

deposits, savings deposits and fixed deposits constitute
an important item on the liabilities side of the balance
sheet.
Borrowings from Other Banks: Under this head, the
bank shows those loans it has taken from other banks.
Bills Payable: These include the unpaid bank drafts
and telegraphic transfers issued by the bank.

 Acceptances and Endorsements: This item appears as

a contra item on both the sides of the balance sheet.
It represents the liability of the bank in respect of bills
accepted or endorsed on behalf of its customers and also
letters of credit issued and guarantees given on their
behalf.
Contingent Liabilities:
Contingent liabilities comprise of those liabilities which are
not known in advance and are unforeseeable.
Every bank makes some provision for contingent liabilities.

 Profit and Loss Account:

The profit earned by the bank in the course of the year is shown
under this head.
Since the profit is payable to the shareholders it represents a
liability on the bank.
Bills for Collection:
This item also appears on both the sides of the balance
sheet.
It consists of drafts and hundies drawn by sellers of
goods on their customers and are sent to the bank for
collection, against delivery documents like railway
receipt, bill of lading, etc., attached thereto.

Assets
Cash:
Here we can distinguish cash on hand from
cash with central bank and other banks cash
on hand refers to cash in the vaults of the
bank.
It constitutes the most liquid asset which
can be immediately used to meet the
obligations of the depositors. Cash on hand
is called the first line of defence to the bank.

 Money at Call and Short Notice:

Money at call and short notice includes
loans to the brokers in the stock market,
dealers in the discount market and to
other banks.
These loans could be quickly converted
into cash and without loss, as and when
the bank requires.

 Bills Discounted:
The commercial banks invest in short term bills
consisting of bills of exchange and treasury bills
which are self-liquidating in character.
These short term bills are highly negotiable and
they satisfy the twin objectives of liquidity and
profitability.
If a commercial bank requires additional funds, it
can easily rediscount the bills in the bill market and
it can also rediscount the bills with the central bank.

 Bills for Collection: As mentioned

earlier, this item appears on both sides
of the balance sheet.
Investments: This item includes the
total amount of the profit yielding
assets of the bank. The bank invests a
part of its funds in government and
non-government securities.

 Loans and Advances: Loans and advances

constitute the most profitable asset to the
bank.
Acceptances
and
Endorsements:
As
discussed earlier, this item appears as a contra
item on both sides of the balance sheet.
Fixed Assets: Fixed assets include building,
furniture and other property owned by the
bank.

INVESTMENT POLICY OF
BANKS
The financial position of a commercial
bank is reflected in its balance sheet.
The balance sheet is a statement of the
assets and liabilities of the bank.
The assets of the bank are distributed in
accordance
with
certain
guiding
principles.

Liquidity
In the context of the balance sheet of a
bank the term liquidity has two
interpretations.
First, it refers to the ability of the bank to
honour the claims of the depositors.
Second, it connotes the ability of the
bank to convert its non-cash assets into
cash easily and without loss.

 Liquidity means the capacity of the bank to

give cash on demand in exchange for
deposits.
But a commercial bank is a profit seeking
institution. It has to arrange its assets in such
a way that it makes maximum profits.
The bank should also maintain the confidence
of public by making cash available on
demand.

 It is a well known fact that a bank

deals in funds belonging to the public.
Hence, the bank should always be on
its guard in handling these funds.
The success of a bank depends to a
considerable extent upon the degree
of confidence it can instill in the minds
of its depositors.

 If the depositors lose confidence in

the integrity of their bank, the very
existence of the bank will be at
stake.

Profitability
The bank has to earn profit to earn income to
pay salaries to the staff, interest to the
depositors, dividend to the shareholders and to
meet the day-to-day expenditure.
Since cash is the least profitable asset to the
bank, there is no point in keeping all the assets
in the form of cash on hand.
The bank has got to earn income. Hence, some
of the items on the assets side are profit
yielding assets.

 They include money at call and short notice,

bills discounted, investments, loans and
advances, etc.
Loans and advances, though the least liquid
asset, constitute the most profitable asset to
the bank.
Much of the income of the bank accrues by way
of interest charged on loans and advances.
But, the bank has to be highly discreet while
advancing loans.

Liquidity Vs Profitability
Cash has perfect liquidity but yields
no return at all, while other incomeyielding assets such as loans are
profitable but have no liquidity.
The bank should strike a balance
between liquidity and profitability

RECONCILING TWIN
OBJECTIVES
A good banker is one who follows a
wise
investment
policy
and
distributes the assets in such a way
that both the requirements of liquidity
and profitability are satisfied.
The more liquid the assets, the less
profitable it is.

Liquidity vs Profitability

Cash :Cash balance have perfect liquidity, but no profitability. Cash is held
to meet the withdrawal needs of depositors.
Money At Call :Surplus cash of commercial banks is lend to each other. This earns
some interest and is also very liquid.
Investment In Securities :Statutorily banks have to invest a part of their assets in government
securities.

These securities have low rate of interest but banks can borrow from
RBI against these securities. Thus investment in securities provide
returns as well as liquidity to bank.

Loans And Advances :Here liquidity is low but profitability is high.

Process of Credit
Creation
The credit creating function of the commercial
banks is the process of multiple-expansion of credit.
The banking system as a whole can create credit
which is several times more than the original
increase in the deposits of a bank.
This process is called the multiple-expansion or
multiple-creation of credit.
Similarly, if there is withdrawal from any one bank,
it leads to the process of multiple-contraction of
credit.

Assumption
(a)The existence of a number of banks, A,
B, C etc., each with different sets of
depositors.
(b) Every bank has to keep 10% of cash
reserves, according to law, and,
(c) A new deposit of Rs. 1,000 has been
made with bank A to start with.

Example
Suppose, a person deposits Rs. 1,000
cash in Bank A.
As a result, the deposits of bank A
increase by Rs. 1,000 and cash also
increases by Rs. 1,000. The balance
sheet of the bank is as fallows:

 Under the double entry system, the amount

of Rs. 1,000 is shown on both sides.
The deposit of Rs. 1,000 is a liability for the
bank and it is also an asset to the bank.
Bank A has to keep only 10% cash reserve,
i.e., Rs. 100 against its new deposit and it
has a surplus of Rs. 900 which it can
profitably employ in the assets like loans.

 Suppose bank A gives a loan to X, who

uses the amount to pay off his creditors.
After the loan has been made and the
amount so withdrawn by X to pay off his
creditors, the balance sheet of bank A
will be as follows:

 Suppose X purchase goods of the value of Rs.

900 from Y and pay cash.
Y deposits the amount with Bank B.
The deposits of Bank B now increase by Rs.
900 and its cash also increases by Rs. 900.
After keeping a cash reserve of Rs. 90, Bank
B is free to lend the balance of Rs. 810 to any
one.

 Suppose bank B lends Rs. 810 to Z, who uses

the amount to pay off his creditors.
The balance sheet of bank B will be as follows:

 Suppose Z purchases goods of the value

of Rs. 810 from S and pays the amount.
S deposits the amount of Rs. 810 in
bank C.
Bank C now keeps 10% as reserve (Rs.
81) and lends Rs. 729 to a merchant.

 The balance sheet of bank C will be as follows:

 Thus looking at the banking system

as a whole, the position will be as
follow:

 It is clear from the above that out of the

initial primary deposit, bank advanced
Rs. 900 as a loan.
It formed the primary deposit of bank B,
which in turn advanced Rs. 810 as loan.
This sum again formed, the primary
deposit of bank C, which in turn
advanced Rs. 729 as loan.

 Thus the initial primary deposit of Rs.

1,000 resulted in bank credit of Rs.
2439 in three banks.
There will be many banks in the
country and the above process of
credit expansion will come to an end
when no bank has an excess reserve
to lend.

 In the above example, there will be 10 fold

increase in credit because the cash ratio is
10%.
The total volume of credit created in the
banking system depends on the cash ratio.
If the cash ratio is 10% there will be 10 fold
increase.
If it is 20%, there will be 5 fold increase.

 When the banking system receives

an additional primary deposit, there
will be multiple expansion of credit.
When the banking system loses cash,
there will be multiple contraction of
credit.

Money Multiplier and Base

Money
Lecture Notes

Subject Guide
Let the total money supply in the
economy, M, be made up of deposits,
D, and the liabilities of the
government, notes and coins, C.
Therefore:
M=D+C

(4.1)

 let high-powered money, H, be made

up of the notes and coins in the
general public, C, and the remainder
of the government's liabilities held by
banks in the form of reserves, R:
H = C + R
(4.2)

 Dividing (4.1) and (4.2) by D and then

dividing one by the other

The bracketed term is the money multiplier:

The factor which, when multiplied by the
base money, gives the total money supply
in the economy.

A simple model of the

banking sector

Assume a banking industry whose

market is described by:

D is the (supply of) bank deposits.

the interest paid on deposits and

i the `market' interest rate.

 The supply of deposits is a positive function

of the interest rate paid on deposits and a
negative function of the market interest rate
the interest rate one could earn elsewhere.

 Where L is the (demand for) bank loans

The demand for loans is a negative function
of the interest rate charged on loans.
If the interest rate you had to pay on a loan
was high relative to the market rate, you
would borrow, not from the bank, but from
elsewhere.

 d0 captures an arbitrary banking

relationship constant.
It represents the minimum an
individual would deposit to the bank
and the minimum a firm receives
from the bank to hold a bank
relationship.

Competitive equilibrium
The profits made by the bank will equal
the quantity of loans, L, multiplied by
the interest earned on those loans, iL
(which is the bank's revenues) minus
the costs faced by the bank.
Costs will equal the interest paid to
depositors in order to encourage them
to hand over their funds to the bank.

 Costs then equal the quantity of deposits, D, times the interest rate
paid on deposits, iD.
Denoting bank profits by
equilibrium, profits equal zero:

and noting that in a competitive

No reserves are kept by the banks

 Bank's balance sheet to balance, loans

(assets) must equal deposits (liabilities).
L = D. Substituting into (4.6) and using
(4.7) implies that in equilibrium:

Substituting into (4.5) and equating L

with D gives:

 Solving for the interest rate on deposits, which equals the interest rate charged
on loans from (4.8), gives

This implies total deposits, D, which equals total loans, L, equals d 0 from either
(4.4) or (4.5).

Equilibrium

Government regulation
of the deposit rate
One way that the government could
reduce or control the money supply is by
setting a limit on the interest rate paid on
deposits.
If the maximum interest rate banks can
pay on deposits is less than i in the above
example, then the amount of funds
savers are willing to deposit with the bank
will fall, resulting in a lower money supply.

Diagram

If government sets the interest rate on deposits equal to zero. From (4.4), the quantity of
deposits is fixed at D = d0 - d1i.

Diagram

The level of deposits, and hence of the money supply, has fallen from d0 to d0 - d1i
because of the government regulation.

Diagram

Since deposits must equal loans in order for the bank's balance sheet to balance
The lower level of deposits means a lower level of loans, which is associated with a
higher interest rate charged, iL > i.

Diagram

Since there is a difference between the interest rate charged on loans and that paid on
deposits (which has been set at zero),
The government regulation has allowed the banks to make positive profits.

Reserves
banks will try to keep a fraction of their
assets in liquid form in order to meet the
day-to-day needs of depositors who
withdraw their funds.
Assume that the government introduces a
mandatory reserve ratio, r*.
The bank's assets now comprise loans, as
before, but now include these reserves.

 Its liabilities are just the deposits of

its customers.
Assets = Liabilities

Substituting (4.11) into the zero profit

condition, (4.6) and (4.7),

As D cancels out.

 The interest rate charged on loans is now higher than

the interest rate paid on deposits.

This is in order to compensate the banks for holding

reserves, on which it earns no interest.
Total loans are now less than total deposits so each
dollar lent out must earn a higher return than that paid
on each dollar deposited with the bank.
iL then needs to be greater than iD.

 Substitute out L and D from (4.4) and (4.5) into (4.11).

Then substituting out iL from (4.12), show that the rate of interest paid on
deposits is equal to:

 Substitute this out into the supply of

deposits equation, (4.4), and show
that total deposits are given by:

 The equation relate the deposit rate and total deposits

(money supply) to the market interest rate and to the
reserve ratio.
By changing the mandatory reserve ratio, the
government can change the total money supply
through the activities of the banking sector.
However, the way in which D varies with r is uncertain
and depends on the parameters of the model.

 With no reserve requirements we equate L to D

in order for the bank's balance sheet to balance.
In this situation we equate L to (1 r*)D from
(4.11).
Therefore the new intersection results in a lower
value of L but a higher interest rate charged, iL.
Total revenues for the bank, L * iL, could then
increase or decrease depending on the elasticity
of the demand for loans function.

 If the demand for loans is elastic then, if L

falls, revenue will fall.
Banks will be forced to cut the interest paid on
deposits, so iD falls, resulting in fewer deposits
and hence causing the money supply to fall.
If the demand for loans is inelastic, a fall in L,
caused by the reserve ratio, will increase
revenues.
The banks will increase iD and so total deposits
will increase.

Monetary base control

The government can control
supply by directly controlling
interest paid on deposits and
affect it through imposing a
reserve ratio.

the money
the rate of
it can also
mandatory

However, by forcing the banks to hold a

certain level of reserves, not just a reserve
ratio, it can directly control the monetary
base.

 Note that high-powered money equals

reserves plus cash held by the general
public and the government directly
controls the amount of cash in the
economy since it is the monopoly supplier.
The government fixes the amount of bank
reserves, R, at R*.
This explicitly determines the amount of
deposits in the economy since R* = r*D.

 Inverting (4.14) will give an expression

for the market interest rate in terms of
r* and R*.

where

 The level of total deposits, and hence

the supply of money, is determined
by the mandatory requirement that
the banks hold a fixed level of
reserves, R* and have a fixed reserve
ratio, r.

 Changing R will directly affect the

money supply, shifting the vertical D
= R*/r* schedule left or right.
It will necessitate a change in the
market interest rate in order to
achieve equilibrium in the banking
sector.