Money
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Theory of Money Kishor Bhanushali Faculty- Economics IBS-Ahmedabad
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
Conceptually money can be defined as any commodity that is generally accepted as a medium of exchange and measure of value
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
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
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
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
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 highpower money (H) and money multiplier (m)
Money Multiplier 1+ c m= H c + r (1 + t )
m = money multiplier c = currency deposit ratio 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. 2. 3. 4. 5.
the wealth of the community The ease and certainty of securing credit Expectations as to future income receipts Nature and variety of substitute assets 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 central bank and government
c. Contingency reserves etc.
c. Accounts of international agencies such as IMF etc.
B.2. Government deposits
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)
B.4. Loans to financial institutions
A. Credit to Government
B.5. internal bills purchased and discounted
A.1. RBI credit to centre
C. Refinancing gross claims on banks
a. Loans and advances fro RBI to the centre
C.1. refinance of RBI to the banks
b. RBI holding of Treasury Bills, dated securities and rupee coins and small coins
C.2. Fixed investments in commercial bank’s shares/bonds/debentures, e.g. holding of shares of the SBI
A.2. RBI credit to the State Government: Loans and advances to state government
D. Net Foreign Assets
B. Credit to Commercial Sector
D.1. Gold coins and bullion
B.1. Shares/bonds of financial institutions
D.2. Eligible foreign securities
B.2. Ordinary debentures of the cooperative sector
D.3. Balance holding abroad netter for balances in IMF Account No.1. minus India’s quota subscription in rupees
B.3. Debentures of co-operative land mortgage banks
Other Assets : (OA) Physical Assets & Others
Balance Sheet of the Banking Sector Liabilities B. Monetary Liabilities A.1. Demand Deposits d. Current Deposits e. Demand liabilities portion of savings bank deposits f. Margin held against letters of credit g. Balance in overdue fixed deposits, cash certificates and cumulative or recurring deposits h. Outstanding telegraphic transfers, mail transfers and demand drafts i. Unclaimed deposits j. Credit balance in the cash credit account k. Demand portion of participatory certificates l. Deposits held as security for advances payable on demand
A.2. Time liabilities b. Fixed deposits c. Cash certificates d. Cumulative and recurring deposits e. Time liabilities portion of savings bank deposits f. Staff security deposits g. Margin held against LCs if not payable on demand h. Fixed deposits held as securities for advances i. Time deposit portion of PCs A.3. Other Demand and Time Liabilities k. Interest accrued on deposits l. Bills payable m. Unpaid dividends n. Suspense account balances representing amounts due to other banks or public o. Interbank PCs p. Net credit balance in Branch Adjustment Account
A.4. External Liabilities b. Other deposits/schemes as per RBI guidelines c. Non-resident deposits d. Overseas borrowings etc B Non Monetary Liabilities
Balance Sheet of the Banking Sector A. Assets A.1. banks Investment in Domesti Securities c. Approved securities d. 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
A letter of credit is a guarantee by a bank on behalf of its corporate customer that a payment will be made if contractual obligations are met Participation certificate is a security that gives the unit holder the right to a corresponding share of the assets in the mutual fund and the right to share in the return on this asset.
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
Conceptually money can be defined as any commodity that is generally accepted as a medium of exchange and measure of value
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
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
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
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
---------
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 highpower money (H) and money multiplier (m)
Money Multiplier 1+ c m= H c + r (1 + t )
m = money multiplier c = currency deposit ratio 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. 2. 3. 4. 5.
the wealth of the community The ease and certainty of securing credit Expectations as to future income receipts Nature and variety of substitute assets 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 central bank and government
c. Contingency reserves etc.
c. Accounts of international agencies such as IMF etc.
B.2. Government deposits
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)
B.4. Loans to financial institutions
A. Credit to Government
B.5. internal bills purchased and discounted
A.1. RBI credit to centre
C. Refinancing gross claims on banks
a. Loans and advances fro RBI to the centre
C.1. refinance of RBI to the banks
b. RBI holding of Treasury Bills, dated securities and rupee coins and small coins
C.2. Fixed investments in commercial bank’s shares/bonds/debentures, e.g. holding of shares of the SBI
A.2. RBI credit to the State Government: Loans and advances to state government
D. Net Foreign Assets
B. Credit to Commercial Sector
D.1. Gold coins and bullion
B.1. Shares/bonds of financial institutions
D.2. Eligible foreign securities
B.2. Ordinary debentures of the cooperative sector
D.3. Balance holding abroad netter for balances in IMF Account No.1. minus India’s quota subscription in rupees
B.3. Debentures of co-operative land mortgage banks
Other Assets : (OA) Physical Assets & Others
Balance Sheet of the Banking Sector Liabilities B. Monetary Liabilities A.1. Demand Deposits d. Current Deposits e. Demand liabilities portion of savings bank deposits f. Margin held against letters of credit g. Balance in overdue fixed deposits, cash certificates and cumulative or recurring deposits h. Outstanding telegraphic transfers, mail transfers and demand drafts i. Unclaimed deposits j. Credit balance in the cash credit account k. Demand portion of participatory certificates l. Deposits held as security for advances payable on demand
A.2. Time liabilities b. Fixed deposits c. Cash certificates d. Cumulative and recurring deposits e. Time liabilities portion of savings bank deposits f. Staff security deposits g. Margin held against LCs if not payable on demand h. Fixed deposits held as securities for advances i. Time deposit portion of PCs A.3. Other Demand and Time Liabilities k. Interest accrued on deposits l. Bills payable m. Unpaid dividends n. Suspense account balances representing amounts due to other banks or public o. Interbank PCs p. Net credit balance in Branch Adjustment Account
A.4. External Liabilities b. Other deposits/schemes as per RBI guidelines c. Non-resident deposits d. Overseas borrowings etc B Non Monetary Liabilities
Balance Sheet of the Banking Sector A. Assets A.1. banks Investment in Domesti Securities c. Approved securities d. 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
A letter of credit is a guarantee by a bank on behalf of its corporate customer that a payment will be made if contractual obligations are met Participation certificate is a security that gives the unit holder the right to a corresponding share of the assets in the mutual fund and the right to share in the return on this asset.
