One Shot Business Economics

Money Market

By- Jasmeet Sir

Unit 1 The Concept of Money Demand: Important Theories
 Topic : Money – Meaning and Basics

Money refers to assets which are commonly used and accepted

1. As a means of payment or
2. As a medium of exchange or
3. Medium of transferring purchasing power.
(a) Anything that would act as a medium of exchange is not necessarily money. For
example, a bill of exchange may also be a medium of exchange, but it is not
money since it is not generally accepted as a means of payment. Money is a
totally liquid asset as it can be used directly, instantly, conveniently and without
any costs or restrictions to make payments.
(b) In modern days, money is not necessarily a physical item; it may also constitute
electronic records.
 Topic : FIAT MONEY

Fiat money is a government-issued currency that is not backed by a physical

commodity, such as gold or silver, but rather by the government that issued it.
 Topic : Characteristics of Money

Money, though not having any inherent power to directly satisfy human wants, by acting as a
medium of exchange, it commands purchasing power and its possession enables us to
purchase goods and services to satisfy our wants. Following are characteristics of Money
1. Generally Acceptable: Anything which is used as money must be easily accepted by all.
2. Durable or Long-lasting: Money don’t get spoilt or destroyed easily.
3. Cognizability: money is easily recognizable and distinguishable.
4. Difficult to Counterfeit: Not easily reproducible by people
5. Relatively Scarce but has elasticity of supply
6. Portable or easily transported: It is easy to carry from one place to another.
7. Possessing Uniformity: Money of a particular denomination must be identical in all
features; and
8. Divisibility: Divisible into smaller parts in usable quantities or fractions without losing
value.
 Topic : Demand for Money

1. Demand for money is people’s desire to hold money and this demand is derived
demand.
2. The Demand for Money is because of its liquidity and ability to store value.
3. Demand for money reflects decision about how much of individual’s wealth is held
as money.
4. Although money gives little or no return (unlike other assets), economic agents
hold money. This is because it is the most liquid and convenient way to accomplish
the daily tasks
5. Demand for money plays significant role in determination of economy’s interest,
prices and income.
6. Variables or factors which influence demand for money are:
(a) Income and Expenditure: Higher the income and expenditure, higher will be
the demand of the money. This is because with the higher income the tendency
to expend will also rise and thus demand will also rise i.e. there is direct
relation of income and demand for money.
(b) General price Index: If the general price index is high, high should be the
holding of money.
(c) Interest (Opportunity cost): Opportunity cost is the interest rate a person
could earn on other assets. Thus, higher the rate more will be temptation to
invest in other assets i.e. there is inverse relationship between interest rate and
demand for money.
(d) Degree of Financial Innovation: Financial innovation like internet banking,
ATM, UBI based payments etc. reduces the need of holding the money. Google
pay and Paytm
 Topic : Theories of Demand for Money

1. Classical Approach or Fisher's Approach - Quantity theory of Money (QTM)

2. Neo-classical Approach or Cambridge Approach - Cash Balance Approach
3. Liquidity Preference Theory - Keynesian Theory
4. Post Keynesian Theories –
(a) Inventory Approach- Baumol
(b) Friedman Theory, and
(c) Demand for Money as Behavior towards Risk-Tobin
 Topic : Classical Approach – Quantity
Theory of Money [QTM]
1. The quantity theory of money was propounded by Irving Fisher of Yale University in his
book “The Purchasing Power of Money” published in 1911.
2. This approach suggests that the money is demanded only for Transaction purpose.
3. It shows a strong relationship between money and price level. The theory asserts that
quantity of money is the main determinant of price level.
4. As per Fisher’s approach, Supply of Money = Demand of Money
MV = PT
Where,
M = Total Amount of Money in circulation
V = Transaction Velocity of Circulation- means average number of times a unit of money is
spent in purchasing goods and services.
Note: Velocity of money remains Constant
P = Average Price Level
T = Total Number of Transactions
5. Higher the number of transactions, greater will be demand for money.
6. There is aggregate demand of money for transaction purpose.
7. Fisher later extended this equation. The expanded equation can be written as
MV + M’V’ = PT
Where,
M’ = Total quantity of credit money
V’ = Velocity of circulation of credit money
7. The demand of money (PT) is equal to the supply of money MV + M’V’
8. Fisher did not mention anything about money demand. However the same is
embedded in his theory as dependent variable on total value of transactions.
 Topic : Cash Balance Approach/NEO Classic
Approach/Cambridge Approach

1. In the early 1900s, Cambridge Economists Alfred Marshall, A.C. Pigou and others
put forward neo- classical theory or cash balance approach.
2. As per the Cambridge version the demand of the money is because of the following
two reasons-
(a) Transaction Motive: Money split-up sale and purchase to two different points of
time rather than being simultaneous. i.e. avoiding double coincidence of wants.
(b) Precautionary Motive: Acting as a hedge against uncertainty.
3. As per this theory, demand for money depends partly on income and partly on
other factors such as interest rates, wealth etc.
4. Higher the income, the greater the quantity of purchases and as a result greater will
be the need for money as temporary abode of value to overcome Transaction cost
5. Cambridge equation is stated as
Md = k PY
Where,
Md = Demand for money
K = Cambridge k (proportion of nominal income that people wish to hold as cash
balances)
P = Average price level of goods and services
Y = Real national income (Output) [Constant as Economy is operating @ full
employment level]
PY = Nominal Income
Higher the income, higher will be the quantity purchased and thus greater money
amount of money will be needed.
 Topic : Liquidity Theory of Demand/Keynesian
Theory of Demand For money

“Liquidity preference” denotes people’s desire to hold money rather than securities or
longterm interest- bearing investments”
According to Keynes, people hold money (M) in cash for three motives:
1. Transactions motive,
2. Precautionary motive, and
3. Speculative motive.
4. Total demand for money = Transaction Demand + Precautionary Demand + Speculative Demand
1. Transaction Motive
(a) It represents need for cash for carrying out current transaction for personal and
business exchange.
(b) This need arises due to timing gap between Receipt of Income and Planned
Expenditures.
(c) This need is further classified into-
(i) Income motive (for individuals & households), and
(ii) Trade Motive (for Business Firms).
(d) Transaction Demand is directly related to the level of Income and unaffected by
interest rates.
Transactions Demand (Lr) = KY
Where,
Y= Earnings
K= Ratio of income which is kept for transaction purposes
(e) Keynes considered that aggregate demand for transaction purpose is a function
of national income
2. Precautionary Motive
(a) Individuals & businesses keep a portion of their income to finance unforeseen,
unpredictable and unanticipated Expenditures.
(b) Precautionary demand depends on the size of income, prevailing economic &
political conditions and personal traits of the individual such as Optimism /
pessimism, farsightedness etc.
(c) Precautionary Motive Cash Balances are considered Income- Elastic and by
itself not very sensitive to Rate of Interest.
3. Speculative Motive
(a) This need reflects people’s desire to hold cash, in order to be equipped to exploit any
attractive investment opportunity requiring cash expenditure. i.e. to take advantage of
favorable business situation
(b) The theory explains the portion of cash to be kept in asset portfolio depending upon
the interest rate prevailing.
(c) In Keynes theory, rate of interest refers to the returns on bond.
(d) Higher the interest rate, lower the speculative demand for money, and vice-versa.
(e) According to Keynes, people demand to hold money balances to take advantage of the
future changes in the rate of interest, which is the same as future changes in bond
prices.
(f) Keynes assumed that the expected return on money is zero, while the expected
returns on bonds are of two types, namely:
(i) The interest payment
(ii) Capital gain.
 (g) The market value of bonds and the market rate of interest are inversely related.
A rise in the market rate of interest leads to a decrease in the market value of
the bond, and vice versa.
(h) Investors have a relatively fixed conception of the “normal” or “critical” interest
rate RC and compare the current rate of interest RN with such “normal” or
“critical” rate of interest.
If current Rate (Rn) > Critical Rate (Rc)
Investors expect a fall in the Interest Rate (rise in Bond Prices), and now they will
convert their cash into Bonds since
1. They can earn high rate of return on Bonds.
2. They expect Capital Gains resulting from a rise in Prices.
If Current rate (Rn) < Critical Rate (Rc)
Investors expect a rise in Interest Rate (fall in Bond Prices), and hence they hold their
wealth in Liquid Cash because
1. Loss, i.e Interest foregone is small.
2. Anticipated capital losses (fall in prices) is avoided.
3. Return on Money will be high than that on Bonds.
4. If interest rate does increase in the future, the bond price will fall, and idle cash
balances can be used to buy bonds at a lower price and thereby, investors make
capital gain.
Asset portfolio would consist wholly of Money / Cash.
If current & Critical Interest Rate is equal, a wealth holder is indifferent to either
holding Cash or Bonds.
 Topic : Post-Keynesian Developments in
the Theory of Demand for money

Post Keynesian theories mainly highlight the store of value/asset function of money.
These Theories are as follows:
1. Inventory Approach to transaction balances
(a) Baumol and Tobin developed a deterministic theory of transaction demand for
money, known as Inventory Theoretic Approach.
(b) In this approach “real cash balance” was essentially viewed as an inventory held
for transaction purposes.
(c) Inventory models assume that there are two media for storing value-
(i) Money
(ii) interest-bearing alternative financial asset.
• As per Baumol, receipt of income, say Y takes place once per unit of time but
expenditure is spread at a constant rate over the entire period of time. Excess
cash over and above what is required for transactions during the period under
consideration will be invested in bonds or put in an interest-bearing account.
Money holdings on an average will be lower if people hold bonds or other
interest yielding assets.

• The higher the income, the higher is the average level or inventory of money
holdings i.e. there us direct relation between income level and average level of
money holdings.

• Holding cash involves opportunity cost and thus they hold an optimum
combination of Bonds and cash balance to minimize the opportunity cost.

• Individual or business firms try to hold optimum cash balance so that balance
• between opportunity cost and transaction cost is met.
• As per Baumol model, optimum cash balance is given by
(2AT/i)1/2
Where,
A= annual cash requirement
T= transaction cost per transaction
I= interest per annum
FRIEDMAN’S THEORY
1. Milton Friedman (1956) treats the demand for money as for demand for capital assets.
2. According to this theory, demand for money is affected by:
a) permanent income ( present expected value of all future income)
b) relative return on assets
3. Friedman stated that permanent income and not the current income as stated in Keynesian
theory determines the demand for money
4. According to Friedman, there are 4 determinants of demand for money. The nominal demand
for money:
a) Is a function of total wealth (permanent income / discount rate). It includes average return
on five asset classes, viz., Money, Bonds, equity, physical capital and human capital
b) Is positively related to price level
c) Is inversely related to opportunity cost of money holdings (returns on bond and stock)
d) Is influenced by inflation. Positive inflation reduced the real value of money balances and
thus, raises the opportunity cost of money holdings. Ultimately, it results in lower demand for
money holdings.
Demand for money as a behaviour towards risk

1. Tobin Present the theory of risk averse individual’s behavior in his article “ Liquidity
2. Preference as Behaviour towards Risk”(1958)
3. The theory suggests negative relationship between demand for money and interest rate.
4. Tobin argues that optimal portfolio structure is determined by:
a) Risk/Reward characteristics of different assets
b) Taste of individual in maximizing his utility consistent with existing opportunities.
5. Tobin asserted that individual would hold some portion of wealth in the money form as rate of
return on holding money is more certain and involves no capital gain or losses,unlike other
assets.
6. Since expected return from alternative assets is more than that of money, individuals hold
some portion of wealth in the form of other financial assets.
7. According to Tobin, risk-averse individuals prefer to hold optimal wealth portfolio which
consists of both, bonds and money.
8. Although overall return would be higher if portfolio consists of only bonds, risk averse
investor is ready to sacrifice some extent of higher return for lowering risk.
9. Theory asserts that demand for money as a store of wealth varies inversely with interest rate.
QUESTION

#Q. Higher the __________ higher would be __________ of holding cash and lower will be
the __________.

A demand for money, opportunity cost, interest rate

B price level, opportunity cost, interest rate

C real income, opportunity cost, demand for money

D interest rate, opportunity cost, demand for money

QUESTION

#Q. The Cambridge approach to quantity theory is also known as

A Cash balance approach

B Fisher’s theory of money

C Classical approach

D Keynesian Approach
QUESTION

#Q. Real money is

A nominal money adjusted to the price level

B real national income

C money demanded at given rate of interest

D nominal GNP divided by price level

QUESTION

#Q. The precautionary money balances people want to hold

A as income elastic and not very sensitive to rate of interest

B as income inelastic and very sensitive to rate of interest

C are determined primarily by the level of transactions they expect to make in the
future.
D are determined primarily by the current level of transactions
QUESTION

#Q. Speculative demand for money

A is not determined by interest rates

B is positively related to interest rates

C is negatively related to interest rates

D is determined by general price level

Unit 2 Money Supply
 Topic : Meaning

Supply of Money - Whether Stock or Flow?

Supply of • It refers to the total amount of Money at any particular point of

Money time. It is a Stock Concept
• Change in the Stock of Money (i.e. increase or decrease per month
or year), is a Flow Variable.
Stock of • Generally, Stock of Money refers to the Stock of Money available to the
Money 'Public' as means of payments and store of value.
• Such Stock of Money is always less than the Total Stock of Money that
really exists in an Economy.
 Topic : Public

The term 'Public' includes all Economic The term 'Public' excludes Producers of
Units - Money
(a)Households, Firms and Institutions, (a) Government, which includes -
(b)Quasi Government Institutions, • Central Government and
(c)Non-Banking Financial Institutions,
• All State Governments and
(d)Non-Departmental Public-Sector
Undertakings, • Local Bodies.
(e)Foreign Central Banks and Foreign (b) Banking System, which means -
Governments, and
• Reserve Bank of India, and
(f)International Monetary Fund which
holds a part of Indian Money in India • All Banks that accept Demand Deposits
in the form of Deposits with RBI. (CASA)
 Topic : Significance of measuring Money Supply

Empirical Analysis of Money Supply is important for the following reasons –

1. Macro-Economic Impact: Money Supply is considered as a very important Macro-
Economic Variable responsible for changes in many other significant Macro-
Economic Variables in an Economy.

2. Economic Stability: Economic Stability requires that the Supply of Money at any
time should be maintained at an Optimum Level. This can be achieved by
accurately estimating the Stock of Money Supply on a regular basis, and
appropriately regulating it in accordance with the Monetary Requirements of the
Country.
 Topic : Significance of measuring Money Supply

3. Analysis: Money Supply analysis facilitates analysis of Monetary Developments to

provide a better understanding of the causes of Money Growth.

4. Monetary Policy: Analysis of Money Supply is essential from the Monetary Policy
viewpoint, as it provides a Framework to -
(a) evaluate whether the Stock of Money is consistent with the Standards for
Price Stability, and
(b) understand the nature of deviations from this Standard.
 Topic : Significance of measuring Money Supply

5. Money Supply and Monetary Policy: The Central Banks all over the World adopt
Monetary Policy to stabilize Price Level and GDP Growth by directly controlling
the Supply of Money. This is achieved mainly by managing the Quantity of
Monetary Base. The success of Monetary Policy depends to a large extent on the
controllability of Money Supply.
 Topic : Sources of Money Supply

There are two broad sources of Money Supply, i.e. High Powered Money, and Credit
Money. These are explained as under

Sources of Money Supply

High Powered Money / Fiat Money Credit Money,

i.e. Currency issued by the Central Bank i.e. Money created by the Commercial Banks
 Topic : Measurement of Money Supply in India

In India, the Central Bank (i.e. RBI) has formulates various Aggregates for measurement

Monetary Aggregates
RBI regards these 4 Measures of Money Stock as representing different degrees of
Liquidity. (M1, M2, M3, M4)
 Topic : Measurement of Money Supply in India

M1 = Currency held by the Public + Net Demand Deposits of Banks (CASA

Deposits) + Other Deposits with the RBI.
Note: Net Demand Deposits = Total Demand Deposits Less Inter-Bank
Deposits.
M2 = M1 + Savings Deposits with Post Office (PO) Savings Banks.
M3 = M1 + Net Time Deposits with the Banking System.
M4 = M3 + Total Deposits with PO Savings Banks (excluding National Savings
Certificates)

Note: Note: M1 is called Narrow Money, while M4 is called Broad Money M1 is the most
liquid while M4 is the least liquid.
 Topic : Determinants of Money Supply

• Central Bank Behaviour: As per this Approach, Money Supply is determined

exogenously by the Central Bank.
• Public Behaviour: Money Supply is determined endogenously by changes in the
economic activities which affect people's desire to hold Currency relative to
Deposits, Rate of Interest, etc.
• Combined Behaviour: Supply of Nominal Money in the Economy is determined
by the joint behaviour of the Central Bank, the Commercial Banks and Public.
[Money Multiplier Approach.]
 Topic : Money Multiplier Approach to Supply of Money

A. Money Multiplier Approach considers 3 Factors as Determinants of Money

Supply, namely –

1. Stock Of High-Powered Money (H) [Behaviour Of The Central Bank]

• Its control over the Issue of Currency is reflected in the Supply of
Nominal High-Powered Money.
• With all other variables unchanged, Total Supply of Nominal Money
will vary directly with the Supply of Nominal High-Powered Money.
 Topic : Money Multiplier Approach to Supply of Money

A. Money Multiplier Approach considers 3 Factors as Determinants of Money

Supply, namely –

2. Ratio Of Reserves To Deposits (RDR) [Behaviour Of The Commercial Banks]

• RDR = 𝑅/D
• RDR (Reserves to Deposits Ratio) represents the behaviour of the
Commercial Banks, in determining Money Supply through "Credit
Money".
• The behaviour of the Commercial Banks is reflected in the Ratio of
their Cash Reserves to Deposits, known as the "Reserve Ratio" (RDR).
 Topic : Money Multiplier Approach to Supply of Money

A. Money Multiplier Approach considers 3 Factors as Determinants of Money

Supply, namely –

3. Ratio Of Currency To Deposits (CDR) [Behaviour Of The General Public]

• CDR = 𝐶/D
• CDR (Currency to Deposits Ratio) represents the behaviour of the
General Public, in determining Money Supply.
• They influence the Nominal Demand Deposits of the Commercial
Banks by their decisions in respect of the amount of Nominal Currency
in hand (Money holding as Cash) designated as "Currency Ratio"
(CDR).
 Topic : Money Multiplier Approach to Supply of Money

These Variables are designated as the 'proximate determinants' of the Nominal Money
Supply in the Economy

B. Money Multiplier Approach recognizes the relationship of Money Supply as

M = m × MB
where
M = Money Supply,
m = Money Multiplier Ratio, and
MB = Monetary Base (or) High Powered Money
Note: The higher the MB, higher the Money Supply (M)
 Topic : Money Multiplier Approach to Supply of Money

The lower the Ratios (RDR and CDR), higher the 'm', and hence higher the Money
Supply (M).
From the above equation, Money Multiplier (m) = . 𝑀𝑜𝑛𝑒𝑦 𝑆𝑢𝑝𝑝𝑙𝑦 / 𝑀𝑜𝑛𝑒𝑡𝑎𝑟𝑦 𝐵𝑎𝑠𝑒
 Topic : Money Multiplier Approach to Supply of Money

Illustration: For this Illustration, assume A, B, C, D, E are all Individuals, and X, Y, Z are
Banks.
• A earns ₹ 1,500, and after holding ₹ 500 cash for his purpose, he deposits ₹
1,000 in Cash at Bank X. If the Required RDR is 10%, Bank X will lend ₹ 900 to B,
i.e. it deposits ₹ 900 in B's Account, that B can now use. Now, B owns ₹ 900.
• B buys goods from C, and pays ₹ 900 to C's Bank Y. Now, Bank Y will have an
increase in Cash of ₹ 900, which it may lend ₹ 810 to D after 10% RDR.
 Topic : Money Multiplier Approach to Supply of Money

Illustration: For this Illustration, assume A, B, C, D, E are all Individuals, and X, Y, Z are
Banks.
• D may again deposit this money it in another Bank Z. After keeping 10% as RDR,
₹ 729 can be lent out to E.
• This process continues "ad infinitum" and Banks thus "create" money supply
called "Credit Money".
• The total of all this Money Supply will be = × 1,000 = ₹ 10,000 So, Initial Deposit
1 10% multiplies itself by 10 times.
 Topic : Money Multiplier Approach to Supply of Money

Money Multiplier Ratio: The Money Multiplier Ratio (m) in the above relationship is
given by the formula
1 + 𝐶𝐷𝑅
M=
𝑅𝐷𝑅 + 𝐸𝑅𝑅 + 𝐶𝐷𝑅

𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑠𝑒𝑟𝑣𝑒
ERR = Excess Reserves Ratio =
𝐷𝑒𝑝𝑜𝑠𝑖𝑡𝑠
 Topic : Impact of RDR on Money Supply & Money Multiplier

A. RDR Concept:
a) When People deposit their Money (Currency) into Banks (as Demand Deposits),
Banks do not hold them as such. Banks create "Credit Money" by using the
deposited money for giving Loans to Individuals I Business Firms, who have to
repay them to the Banking System.
b) The difference between Interest paid (to Public) and Interest Earned (on Loans
given) is called "Spread" and constitutes Gross Income of the Banks, from which
other Expenses are met.
 Topic : Impact of RDR on Money Supply & Money Multiplier

A. RDR Concept:
c) However, every Rupee of Demand Deposits cannot be given away as Loans, since
Banks are required to hold back a portion of such Deposits as "Reserves", to
maintain Liquidity in the Banking System. This Ratio is called as RDR (Reserves
to Deposits Ratio).
d) If Reserves increase, then Money Supply will be reduced. Hence, Money Supply
is inversely related to RDR.
 Topic : Impact of RDR on Money Supply & Money Multiplier

A. RDR Concept:
e) Reserves may be as the result of -
• the Regulations of the Central Bank (RBI) - referred as Statutory Reserves,
or
• decisions taken by the Commercial Banks themselves - referred as Excess
Reserves.
 Topic : Impact of RDR on Money Supply & Money Multiplier

Impact of Statutory Reserves

Situation 1 Central Bank decreases Statutory Reserve Ratio on Demand Deposits

There will be expansion of Loans by Banks, hence expansion of Deposits by Public
(since money flow happens), since the same level of Reserves can now support more
Loans and Deposits. Thus, Money Supply will increase.
 Topic : Impact of RDR on Money Supply & Money Multiplier

Situation 2 Central Bank increases Statutory Reserve Ratio on Demand Deposits

Since Reserves are needed, Banks will restrict / recall / reduce (i.e. contract) their
Loans, causing a decline in Deposits and hence in the Money Supply.
 Topic : Impact of RDR on Money Supply & Money Multiplier

Situation 3 Central Bank injects Money into Banking System but these are held as
Excess Reserves by the Banking System

Since they do not lead to any Additional Loans, these Excess Reserves do not lead to
creation of Money. There will be no effect on Deposits or Currency and hence no effect
on Money Supply.
 Topic : Impact of RDR on Money Supply & Money Multiplier

Impact of Excess Reserves:

Excess reserve represents the additional reserve maintained by commercial bank with
RBI over and above the minimum required ratio to be kept
Excess Reserve is affected by the Cost and Benefits of holding such Reserves. For this
purpose-
• Cost = Interest that could have been earned by giving these amounts as Loans,
i.e Opportunity Cost,
• Benefit = Assurance as to adequate liquidity in the banking system, to meet
withdrawal of Deposits by Public.
 Topic : Impact of RDR on Money Supply & Money Multiplier

These costs and benefits are influenced by two factors, viz. Market Interest Rates and
Expected Deposits Outflows, which have following impact-

If interest rate increases

Banks will prefer to reduce Excess Reserves and give them as Loans to have higher
earnings. So, the ratio of Excess Reserves to Deposits falls.

If Interest Rate decreases

Opportunity Cost of holding excess Reserves declines and Reserves will rise.
 Topic : Impact of RDR on Money Supply & Money Multiplier

If deposit outflows are expected to increase

Banks will want more assurance against the possibility and will increase the Excess
Reserves Ratio.

If deposit Outflows are expected to decrease

Decline in Expected Deposit Outflows will reduce the benefit of holding Excess
Reserves, consequently, Excess Reserves will rise.
 Topic : Credit Multiplier

a) It describes the amount of Additional Money created by Commercial Bank

through the process of lending the available Money in excess of the Reserve
Requirements, i.e. how much new Money will be created by the Banking System
for a given increase in the High-Powered Money.

b) It reflects a Bank's ability to increase the Money Supply.

c) It is also called "Deposit Multiplier'' or "Deposit Expansion Multiplier".

 Topic : Credit Multiplier

1
(a) Credit Multiplier =
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑅𝑎𝑡𝑖𝑜
(b) The Deposit Multiplier and Money Multiplier are closely related, but are not
identical because -
• Generally Banks do not lend out all of their available money but instead
maintain Excess Reserves..
• All Individuals / Borrowers do not spend every Rupee they have earned /
borrowed. They are likely to hold / convert some portion of it to Cash.
 Topic : Impact of CDR on Money Supply &
Money Multiplier

1. CDR Concept: CDR is the ratio of money held by the Public held in Currency, to
𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 ℎ𝑒𝑙𝑑 𝑏𝑦 𝑃𝑢𝑏𝑙𝑖𝑐
that they hold in Demand Deposits, with Banks. So, CDR =
𝐷𝑒𝑚𝑎𝑛𝑑 𝐷𝑒𝑝𝑜𝑠𝑖𝑡𝑠 𝑖𝑛 𝐵𝑎𝑛𝑘𝑠
𝐶
= . Suppose CDR is 0.2, it means for every ₹ 100, an Individual with hold ₹ 20 as
𝐷
Currency with him, and place ₹ 80 in Commercial Banks as Demand Deposits.
 Topic : Impact of CDR on Money Supply &
Money Multiplier

2. Significance: CDR -
(a) represents the degree of adoption of banking habits by the people, and is
thus a behavioural parameter,
(b) reflects People's preference for liquidity,
(c) is related to the level of economic activities or the GDP Growth,
 Topic : Impact of CDR on Money Supply &
Money Multiplier

2. Significance: CDR -
(d) is influenced by the degree of financial sophistication, e.g. (i) ease and
access to Financial Services, (ii) availability of a number of Liquid Financial
Assets, (iii) Financial Innovations, (iv) Institutional Factors, etc.
(e) is driven by temporary factors also, e.g. CDR may increase during festive
seasons as People convert Deposits into Cash for meeting extra expenditure
during that periods.
 Topic : Impact of CDR on Money Supply &
Money Multiplier

3. Impact: Increase in the Monetary Base that goes into -

(a) Currency - is not multiplied.
(b) Demand Deposits - is multiplied (by the Banking System, subject to Reserve
Requirements)
 Topic : Impact of Other factors on Money Supply &
Money Multiplier

A. Effect of Government expenditure on Money supply-

a) Whenever the Central and State Governments‟ cash balance falls short of
the Minimum requirement, they are eligible to avail of the facility called
Ways & Means Advances (WMA) / Overdraft (OD) Facility.
b) When Government incurs expenditure, it involves debiting Government
balances with RBI, and Crediting the Receiver (e.g. Salary Account of
Employee) Account with the Commercial Bank.
 Topic : Impact of Other factors on Money Supply &
Money Multiplier

A. Effect of Government expenditure on Money supply-

c) So, it results in generation of Excess Reserves, (i.e. excess balances of
Commercial Banks with RBI).
d) Excess reserves thus created can potentially lead to an increase in Money
supply through the Money Multiplier process e.g. When the Employee uses
this money for making payments for purchase of goods etc.
 Topic : Impact of Other factors on Money Supply &
Money Multiplier

B. Effect of Time deposits (Note: RDR requirements generally relate to Demand

Deposits, not Time Deposits)
An increase in Time Deposit – Demand Deposit Ratio means that greater
availability of Free Reserves and consequent enlargement of volume of Money
Supply.
QUESTION

#Q. M1 is the sum of

currency and coins with the people + demand deposits of banks (Current and
A
Saving accounts) + other deposits of the RBI.
currency and coins with the people + demand and time deposits of banks
B
(Current and Saving accounts) + other deposits of the RBI.

C currency in circulation + Bankers' deposits with the RBI + Other deposits with the
RBI

D none of the above

QUESTION

#Q. Banks in the country are required to maintain deposits with the central
bank

A to provide the necessary reserves for the functioning of the central bank

B to meet the demand for money by the banking system

C to meet the central bank prescribed reserve requirements and to meet

settlement obligations.
D to meet the money needs for the day to day working of the commercial banks
QUESTION

#Q. The size of the money multiplier is determined by

A the currency ratio (c) of the public

B the required reserve ratio (r) at the central bank, and

C the excess reserve ratio (e) of commercial banks

D all the above

QUESTION

#Q. ________________ tells us how much new money will be created by the banking
system for a given increase in the high-powered money.
A The currency ratio

B The credit multiplier

C The excess reserve ratio (e)

D The currency ratio (c)

QUESTION

#Q. The money multiplier will be large

for higher currency ratio (c), lower required reserve ratio (r) and lower excess
A
reserve ratio (e)
for constant currency ratio (c), higher required reserve ratio (r) and lower excess
B
reserve ratio (e)

C for lower currency ratio (c), lower required reserve ratio (r) and lower excess
reserve ratio (e)

D None of the above

QUESTION

#Q. For a given level of the monetary base, an increase in the required reserve ratio
will denote
A a decrease in the money supply

B an increase in the money supply

C an increase in demand deposits

D Nothing precise can be said

QUESTION

#Q. For a given level of the monetary base, an increase in the currency ratio causes
the money multiplier to _________ and the money supply to ________.

A decrease; increase

B increase; decrease

C decrease; decrease

D increase; increase
QUESTION

#Q. If commercial banks reduce their holdings of excess reserves

A the monetary base increases

B the money supply increases

C the monetary base falls

D the money supply falls

Unit 3: Monetary Policy
 Topic : Meaning Of Monetary Policy

Reserve Bank of India uses monetary policy to manage economic fluctuations and
achieve price stability, which means that inflation is low and stable.

Reserve Bank of India conducts monetary policy by adjusting the supply of money,
usually through buying or selling securities in the open market.
 Topic : THE MONETARY POLICY FRAMEWORK

Framework which has three basic components, viz.

(i) the objectives of monetary policy,

(ii) the analytics of monetary policy which focus on the transmission mechanisms,
and
(iii) The operating procedure which focuses on the operating targets and instruments.
 Topic : The Objectives of Monetary Policy

Objectives Of Monetary Policy

The monetary policy of such countries also incorporates explicit objectives such as:
(i) Maintenance the economic growth,
(ii) Ensuring an adequate flow of credit to the productive sectors,
(iii) Sustaining - a moderate structure of interest rates to encourage investments, and
(iv) creation of an efficient market for government securities.
(v) Debt management
(vi) Price stability (controlling inflation)
 Topic : Transmission of Monetary Policy

The transmission of the monetary policy describes how changes made by the Reserve
Bank to its monetary policy settings flow through to economic activity and inflation.
the transmission can be summarised in two stages:

1. Changes to monetary policy affect interest rates in the economy.

2. Changes to interest rates affect economic activity and inflation.
 Topic : CHANNELS OF MONETARY POLICY TRANSMISSION

Saving and Investment Channel

Lower interest rates on Reduce the incentives households must save their money &
bank deposits instead there is an increased incentive for households to
spend their money on goods and services.
Lower interest rates Encourage households to borrow more and support higher
for loans demand for assets, such as housing.

Lower lending rates Increase investment spending by businesses (on capital

goods like new equipment or buildings).
 Topic : CHANNELS OF MONETARY POLICY TRANSMISSION

Cash-flow Channel
A reduction in Reduces interest repayments on debt, increasing the amount of
lending rates cash available for households and businesses to spend on goods
and services

a reduction in Reduces the amount of income that households and businesses get
interest rates on from deposits, and some may choose to restrict their spending.
deposits
 Topic : CHANNELS OF MONETARY POLICY TRANSMISSION

Asset Prices and Wealth Channel

The asset prices and wealth channel typically affects consumption and investment.
Lower interest Support asset prices (such as housing and equities) by
rates encouraging demand for assets

Higher asset prices Increase the equity (collateral) of an asset that is available for
banks to lend against. This can make it easier for households and
businesses to borrow.

An increase in asset prices increases people's wealth. This can lead to higher
consumption and housing investment as households generally spend some share
of any increase in their wealth.
 Topic : CHANNELS OF MONETARY POLICY TRANSMISSION

Exchange Rate Channel

1. The exchange rate can have an important influence on economic activity and
inflation. It is typically more important for sectors that are export-oriented or
exposed to competition from imported goods and services.
2. If the Reserve Bank lowers interest rates in India, it reduce the returns investors
earn from assets in India. Lower returns reduce demand for assets in India with
investors shifting their funds to foreign assets (resulting into lower demand of
rupee)
3. A reduction in interest rates results in a lower exchange rate, This leads to an
increase in exports and domestic activity. A lower exchange rate also adds to
inflation because imports become more expensive in Indian rupees.
 Topic : Operating Procedures and Instruments

There are three types of Procedures

a) Quantitative Tools
b) Qualitative Tools
c) Market Stabalisation Scheme
 Topic : Operating Procedures and Instruments

Quantitative Tools
i) Reserve Ratio:
Banks are required to keep aside a set percentage of cash reserves or RBI
approved assets. Reserve ratio is of two types:
a) Cash Reserve Ratio (CRR) – Banks are required to set aside this portion in
cash with the RBI. The bank can neither lend it to anyone nor can it earn
any interest rate or profit on CRR.
b) Statutory Liquidity Ratio (SLR) – Banks are required to set aside this
portion in liquid assets such as gold or RBI approved securities such as
government securities. Banks are allowed to earn interest on these
securities, however it is very low.
 Topic : Operating Procedures and Instruments

ii) Open Market Operations (OMO)

In order to control money supply, the RBI buys and sells government securities in
the open market. These operations conducted by the Central Bank in the open
market are referred to as Open Market Operations.
When the RBI sells government securities, the liquidity is sucked from the
market, and the exact opposite happens when RBI buys securities. The latter is
done to control inflation. The objective of OMOs are to keep a check on
temporary liquidity mismatches in the market, owing to foreign capital flow.
 Topic : Operating Procedures and Instruments

Qualitative tools
i) Margin requirements – The RBI prescribes a certain margin against collateral,
which in turn impacts the borrowing habit of customers. When the margin
requirements are raised by the RBI, customers will be able to borrow less.
ii) Moral suasion – By way of persuasion, the RBI convinces banks to keep money in
government securities, rather than certain sectors.
iii) Selective credit control – Controlling credit by not lending to selective industries
or speculative businesses
 Topic : Operating Procedures and Instruments

Market Stabilisation Scheme (MSS) –

i. Bank rate - The interest rate at which RBI lends long term funds to banks is
referred to as the bank rate. Bank rate is used to prescribe penalty to the bank if
it does not maintain the prescribed SLR or CRR.
ii. Liquidity Adjustment Facility (LAF) – RBI uses LAF as an instrument to adjust
liquidity and money supply. The following types of LAF are:
 Topic : Operating Procedures and Instruments

a) Repo rate: Repo rate is the rate at which banks borrow from RBI on a short-term
basis against a repurchase agreement. Under this policy, banks are required to
provide government securities as collateral and later buy them back after a pre
defined time
 Topic : Operating Procedures and Instruments

b) Reverse Repo rate: It is the reverse of repo rate, i.e., this is the rate RBI pays to
banks in order to keep additional funds in RBI. It is linked to repo rate in the
following way:
Reverse Repo Rate = Repo Rate – 1
 Topic : Operating Procedures and Instruments

c) Marginal Standing Facility (MSF) Rate: MSF Rate is the penal rate at which the
Central Bank lends money to banks, over the rate available under the rep policy.
Banks availing MSF Rate can use a maximum of 1% of SLR securities.
MSF Rate = Repo Rate + 1MSF Rate = Repo Rate + 1
QUESTION

#Q. Which of the following is the function of monetary policy?

A regulate the exchange rate and keep it stable

B regulate the movement of credit to the corporate sector

C regulate the level of production and prices

D regulate the availability, cost and use of money and credit

QUESTION

#Q. The main objective of monetary policy in India is

A reduce food shortages to achieve stability

B economic growth with price stability

C overall monetary stability in the banking system

D reduction of poverty and unemployment

QUESTION

#Q. A contractionary monetary policy-induced increase in interest rates

A increases the cost of capital and the real cost of borrowing for firms

B increases the cost of capital and the real cost of borrowing for firms and
households
C decreases the cost of capital and the real cost of borrowing for firms

D has no interest rate effect on firms and households

QUESTION

#Q. __________ is the part of total deposits of commercial banks which they have to
keep with RBI.

A CRR

B SLR

C Bank rate

D Repo rate
QUESTION

#Q. During deflation

A the RBI reduces the CRR in order to enable the banks to expand credit and
increase the supply of money available in the economy

B the RBI increases the CRR in order to enable the banks to expand credit and
increase the supply of money available in the economy

C the RBI reduces the CRR in order to enable the banks to contract credit and
increase the supply of money available in the economy

D the RBI reduces the CRR but increase SLR in order to enable the banks to contract
credit and increase the supply of money available in the economy
QUESTION

#Q. RBI provides financial accommodation to the commercial banks through

repos/reverse repos under

A Market Stabilisation Scheme (MSS)

B The Marginal Standing Facility (MSF)

C Liquidity Adjustment Facility (LAF).

D Statutory Liquidity Ratio (SLR)

QUESTION

#Q. Reverse repo operation takes place when

A RBI borrows money from banks by giving them securities

B banks borrow money from RBI by giving them securities

C banks borrow money in the overnight segment of the money market

D RBI borrows money from the central government

QUESTION

#Q. An open market operation is an instrument of monetary policy which involves

buying or selling of __________ from or to the public and banks
A bonds and bills of exchange

B debentures and shares

C government securities

D none of these