Money & Banking

Contents
Components of money supply
Real versus Nominal interest rates
The demand for money
Functions of money
Process of deposit creation
Balance sheet of Central Bank
Credit control by central bank
The effect of money on output and prices
Money market
Monetary policy in open economy
 Definition of Money
Conceptuallymoney can be defined as any
commodity that is generally accepted as a
medium of exchange and measure of value
The Conventional Definition
 Oldest and most widely used
 Emphasis on the basic functions of money i.e. medium
of exchange and measure of value
 Money is what money does
 Commodity money
The Chicago Approach
 Milton Friedman
 Chicago school defined money to include time deposits
of commercial banks
 Currency + Demand Deposits + Time Deposits
 Time deposits are and demand deposits are close
substitutes
The Gurley – Shaw Approach
 John G Gurley & Edward S Shaw
 Gurley –Shaw approach emphasized the close substitute
relationship between currency, demand deposits,
commercial bank time deposits, savings bank deposits,
savings and loan, shares etc which are regarded as close
substitute of liquid cash
 According to Gurley-Shaw approach money supply
should be defined as a weighted sum of currency,
demand deposits and all the deposits and claims against
the financial intermediaries that can be treated as the
substitute for currency and demand deposits – weights to
be determined on the basis of degree of substitutability
The Central Bank Approach
 Stillbroader view
 Central bank view all available means of payment and
credit flows as money
 Money supply constitute currency plus all realizable
assets, that is assets that can be converted in to money as
will
 Money is in a way the total credit flow to the borrowers
 M1, M2, M3 & M4
 Measures of Money Supply in India
M1 =C+DD+OD
M2 = M1+saving deposits with post offices
M3= M1+Time deposits with the
commercial banks
M4 = M3+total deposits with post offices
Kinds of Money
Metallic money
Paper Money
Bank deposits
Plastic money
Invisible moeny
Functions of Money
Money as a medium of exchange
Money as a measure of value
Money as a store of value
Money as a standard of deferred
payments
Functions of Central Bank
 As a note issuing authority
 As a banker to the State
 As a banker to banks
 Guardian of the money market through credit control
 As the lender of last resort
 Maintenance of external value of the domestic
currency
 Ensure price stability
 Exchange control operations
 Economic stability
 Supply of Money
High powered money
Bank money
Process of credit creation
Deposit multiplier
Dm = ▲D/▲R
Credit multiplier = ▲CC/▲R
Deposit multiplier is the ratio of new deposit
creation to the increase in reserves with the banks
Credit multiplier is the ratio of additional credit
creation to increase in cash reserve ratio
 Credit Creation Process
Bank Liabilities Assets Total Assets

Bank 1 100.00 80.00 20.00 100.00

Bank 2 80.00 64.00 16.00 80.00

Bank 3 64.00 51.80 12.80 64.00

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Bank n 00.00 00.00 00.00 00.00

Total 500.00 400.00 100.00 500.00

Deposit Multiplier
 Primary deposits leads to the creation of secondary or
derivative deposits, which is a multiple of the primary
deposits
 Deposit multiplier is the ratio of new deposit creation to
the increase in reserves with banks
 Deposit multiplier = ▲D/▲R
 Where ▲D is additional deposits created by the banks
including initial deposits
 ▲R is change in cash reserves of the banks
 Deposit Multiplier = ▲D/▲R =1/r (reserve deposit
ratio)
 ▲D = 1/r ▲R
Credit Multiplier
Credit multiplier can be defined as the ratio
of additional credit creation to increase in
the cash reserves
Credit Multiplier = ▲CC/▲R
▲CC = ▲D-▲R
Credit multiplier = 1  r
r
Money Multiplier
M = C+DD
H = C + R
 M = mH
 m = Money multiplier
 High power money is the basic money and it forms the
basis of money creation through monetary transactions
between public and banks
 H is policy determined
 Total supply of money depends on the supply of high-
power money (H) and money multiplier (m)
 Money Multiplier
m = money multiplier
c = currency deposit
1 c
m H ratio
c  r (1  t ) r = reserve deposit ratio
t = time deposit ratio
H = high power money
Money Multiplier
The higher the value of currency deposit
ratio “c”, the smaller the value of multiplier.
If public prefer to hold a high proportion of
H in the form of cash and smaller
proportion of it as deposits, then the ability
of the bank to create secondary deposits and
credit will be reduced
Money Multiplier
Higher the reserve deposit ratio “r’, lower
the value of multiplier. If banks reserve
requirement increases, their ability to create
deposits and credit decreases and
therrefore, the value of “m” decreases
Money Multiplier
Higher the value of ratio of time deposits to
demand deposits “t”, lower the value of
value of “m”. If public decides to increase
the ratio of time deposits to demand
deposits, than the value of “m’ decreases.
Theory of Money Supply
The analysis of how money supplied by
the central bank multiplies itself in the
process if monetary transactions forms the
theory of money supply
Total supply of money depends on the
supply of high-power money and the
money multiplier
Keynesian Approach to Demand for
Money
Transaction demand for money
◦ level of income
◦ Frequency with which the income is received
◦ Frequency with which the expenses are made
Precautionary demand for money
Speculative demand for money
Other determinants of Demand for
Money
1. The wealth of the community
2. The ease and certainty of securing credit
3. Expectations as to future income receipts
4. Nature and variety of substitute assets
5. The system of payments in the
community
Balance Sheet of RBI - Liabilities
A Monetary Liabilities (ML) B. Non-monetary Liabilities
(NML)
A.1. Notes in circulation B.1. Capital account (Net Worth)

A.2. Other Deposits a. Paid up capital

a. Deposits with quasi government b. Statutory reserves

b. Balance in the account of foreign c. Contingency reserves etc.

central bank and government

c. Accounts of international agencies B.2. Government deposits

such as IMF etc.

A.3. Deposits of Banks (Reserves) B.3. IMF a/c No 1 (since 1948)

B.4. Miscellaneous NMLs

e.g. Bills Payable, RBI Employees

pension Fund, Co=operative
Guarantee/Provident Funds, Compulsory
deposit scheme balance etc.
Balance Sheet of RBI - Assets
Financial Assets (FA)
A. Credit to Government
A.1. RBI credit to centre
a. Loans and advances fro RBI to the centre
b. RBI holding of Treasury Bills, dated
securities and rupee coins and small coins
A.2. RBI credit to the State Government:
Loans and advances to state government
B. Credit to Commercial Sector
B.1. Shares/bonds of financial institutions
B.2. Ordinary debentures of the co-
operative sector
B.3. Debentures of co-operative land
mortgage banks
B.4. Loans to financial institutions
B.5. internal bills purchased and discounted
C. Refinancing gross claims on banks
C.1. refinance of RBI to the banks
C.2. Fixed investments in commercial
bank’s shares/bonds/debentures, e.g.
holding of shares of the SBI
D. Net Foreign Assets
D.1. Gold coins and bullion
D.2. Eligible foreign securities
D.3. Balance holding abroad netter for
balances in IMF Account No.1. minus
India’s quota subscription in rupees
Other Assets : (OA) Physical Assets &
Others
Balance Sheet of the Banking Sector
Liabilities
A. Monetary Liabilities
A.1. Demand Deposits
a. Current Deposits
b. Demand liabilities portion of savings bank deposits
c. Margin held against letters of credit
d. Balance in overdue fixed deposits, cash certificates and
cumulative or recurring deposits
e. Outstanding telegraphic transfers, mail transfers and demand
drafts
f. Unclaimed deposits
g. Credit balance in the cash credit account
h. Demand portion of participatory certificates
i. Deposits held as security for advances payable on demand
A.2. Time liabilities
a. Fixed deposits
b. Cash certificates
c. Cumulative and recurring deposits
d. Time liabilities portion of savings bank deposits
e. Staff security deposits
f. Margin held against LCs if not payable on demand
g. Fixed deposits held as securities for advances
h. Time deposit portion of PCs
A.3. Other Demand and Time Liabilities
a. Interest accrued on deposits
b. Bills payable
c. Unpaid dividends
d. Suspense account balances representing amounts due to other
banks or public
e. Interbank PCs
f. Net credit balance in Branch Adjustment Account
A.4. External Liabilities
a. Other deposits/schemes as per RBI guidelines
b. Non-resident deposits
c. Overseas borrowings etc
B Non Monetary Liabilities
Balance Sheet of the Banking Sector
A. Assets
A.1. banks Investment in Domestic Securities
a. Approved securities
b. Other investments
A.2. Loans and Advances
A.3. Vault Cash (part of reserves)
A.4. Deposits with RBI
B Other Assets
B.1. Physical Assets
B.2. Other Assets
 Numerical 1
Net Worth (NML) 740
Credit to Government (A) 1420
Credit to banks (A) 432
Credit to commercial sector (FA) 594
Foreign exchange assets (FA) 202
Other assets (OA) 114
Government Deposits (NML) 42
Deposits of commercial banks (ML) 220
Money supply in the economy 8542
Reserve ratio 7%
Government money 201
Money Multiplier ?
Solution…………..
 Total Assets = 2726
 NML = 782
 ML = (220+1760) = 1980
 H = ML + GM
 H = 1980 + 201 = 2181
 Ms = H *(1+C) / (C+r)
 C = 0.25
 Multiplier = 3.9062
Numerical 2
Foreign Exchange Assets (FA) 15
Credit to Government (FA) 1780
Credit to banks (FA) 410
Government deposits (NML) 21
Other Non Monetary Liabilities (NML) 11
Net Worth (NML) 510
Other assets (OA) 78
Credit to commercial sector (FA) 112
Currency deposit ratio 0.3
Reserve ratio 4%
Government money Negligible
Money Supply ?
Solutions…..
 Total Assets = 2395
 NML = 542
 ML = 1853
 Ms = 7085
Numerical 3
Bank Deposits (ML) 125
Government Deposits (NML) 50
Foreign Exchange Assets (FA) 20
Net Worth (NML) 1000
Other Assets (OA) 50
Other NML (NML) 25
Credit to government (FA) 1750
Credit to banks (FA) 750
Credit to commercial sector (FA) 500
Currency deposit ratio 34%
Government money 5
Total money supply 6000
Reserve Ratio ?
Solution……
 Totalassets = 3070
 NML = 1075
 ML = 1995
 H = ML + GM
 H = 1995 + 5
 Reserve ratio = 10.6%