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CHAPTER – 8 : Money Market

UNIT-1 : The Concept of Money Demand

Theories of Demand for Money

 1. Classical Approach: Quantity Theory – Money (QTM)
This theory was given By - Irving Fisher (Yale University)
Book - The Purchasing Power of Money, Published- 1911
 As per this theory
 money is demanded only for transaction purpose
 There is a relationship b/w money & price level i.e. quantity of money mainly determines the price levels
, income & interest rates ,
 equation
 Supply of money = Demand of money
MV = PT
M = Total amount of money in circulation
V = Transaction velocity of circulation
P = Average price level
V = Total no. of transaction
 Extension of earlier equation when credit money is considered
MV + M'V' = PT
 M' = Total quantity of credit money
 V' = Velocity of circulation credit money
 PT = denotes demand of money
 T remains fixed in short run due to full employment
 There is aggregate demand of money for transaction purpose
 More no. of transactions, greater demand for money

 2. The Cambridge Approach

By - Alfred Marshall, A.C. Pigou, D.H. Robertson, John Maynard Keynes (Cambridge)
Known as Cash Balance Approach in Early 1900's
 As per this approach there are 2 Ways that money increases utility
 1. enabling split up of sale & purchase into different points in time
 2. being a Hedge against uncertainty
 demand for money depends partly on income and partly on other factors like wealth & interest rate .

 higher the income, greater the quantity of purchase, this will result in greater need for money a "temporary
abode" of value to overcome transaction cost.
 Approach (eq)
Md = kPY
Md = demand for money
V = Cambridge K (proportion of nominal income held as cash

Captain Love Kaushik

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P = average price levels (good/services)

PY = nominal income
Y = national output

 3. Keynesian Theory of Demand for Money

This theory was given By – John Maynard Keynes
This theory is also known as – Liquidity Preference Theory
Book – General theory of Employment, Interest and Money known in 1936


 As per this theory there are 3 Motives of to hold money
 Transaction motive
 Precautionary motive
 Speculation motive

 Transaction motive
 It relates to the need for cash for current transactions for personal and business exchange

 Direct relationship b/w transaction demand and level of income. (unaffected by interest rates)
 Equation:
Mr = kY
Lr = Transaction demand for money
k = ratio of earning
 Conclusion:
Aggregate demand for money for transaction purpose = f (national income)

 Precautionary Motive
 Individuals and businesses keep a portion of income to finance uncertainties (unanticipated expenditure)
 As per this motive , money demand Dependents on :
 Size of income
 Prevailing economic and political conditions
 Personal characterization (pessimistic / optimistic)
 Conclusion:
 Precautionary motive cash balance is income elastic
 Not sensitive to interest rates
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 Speculative Demand for Money (SDM)

 SDM Desire to hold cash in order to be equipped to exploit any attractive instrument opportunity requiring
cash expenditure
 In Keynes theory interest (i) = equal interest of bond
 Assuming interest of money holding in cash = 0

Returns on bonds of 2 types

Interest Payment Expected rate of capital growth

 markets rate of interest and market value of phones are inversely related
 higher interested means lower speculation demand for money vice versa

 If current rates > Critical Rates (Rn > Rc)

Interest Expects: fall in interest rates i.e. rise in bond prices and hence will convert cash to bonds as–
1. can earn high rate of returns on bonds
2. expect capital gains from rise and price

 If current rates < Critical rates (Rn < Rc)

Interest expects: rise in interest rates will hold wealth in liquid cash as-
1. Loss by way of interest forgone in small
2. Anticipated capital loses are avoided
3. Return on money > bonds
4. If interest rate increases, bond prices will fall and ideal cash balance will be used to buy bonds at cheap
prices.

 1. Individual Speculation Demand

 Discontinuous portfolio decision of individuals
 Rn = current rate
Rc = critical rate
 Rn > Rc, individuals hold extra wealth in form of bonds
 Rn < Rc, individuals hold wealth in form of speculation cash
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 2. Aggregate Speculation Demand

Observation
 When we go from individual speculation demand to aggregate speculation demand, discontinuity in demand
curve disappears.
 We get Continuous downward sloping demand function
 Inverse relationship b/w current rate of interest and speculative demand for money.

Liquidity Trap
Situation  Expansionary monetary policy does not increase interest rates, income or stimulate the
economy.
Preference  Public prefers to hold money unaffected by interest rate, e.g., during war or deflation.

Investors  Investors hold cash instead of bonds

Elasticity  Speculative demand becomes perfectly elastic with respect to change in interest rates, curve
becomes parallel to axis
Policies  Monetary policies cannot stimulate economic growth. Expansionary monetary policy
becomes ineffective.
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Cost  Opportunity cost of holding money is 0; with increased money supply, people still hold cash

Post Keynesian Theories - Demand for Money

Demand for Money - Behaviour

Inventory Approach Friedman Theory
Towards Risk

 1. Inventory Approach to Transaction Balance

This theory was By – Baumol (1952) and Tobin (1956)
This theory is also known as Known as – Inventory Theoretic Approach
As per this Approach – “Real cash balance” was viewed as inventory held for transaction purpose
 Inventory models assume 2 media of storing values
 1. Money
 2. Interest bearing alternative financial purpose
 Transfer Flow

Fixed Cost
Money Alternative Assets
(eg. Brokers)

 Liquid financial assets other than money (eg.- bank deposits) offer positive return which justify the above
said transaction cost between money and assets.

Baumol’s Approach
Transaction  Individuals hold money for transaction purposes
Cost  Cost incurred while holding money inventory, i.e., interest foregone
Opportunity  Foregone cost is called opportunity cost
Assets  Alternative assets like bonds and shares are riskier than holding money
Savings  Savings deposits in bank are relatively safe and earn some interest
Demand  Transaction demand for money depends on the interest rate
Transfer  Cost of transferring between money and assets (e.g., brokerage fees) affects the transfer
frequency
 Baumol proves that the average amounts of cash withdrawal which minimizes cost is given by

√
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 2. Friedman’s Restatement of Quantity Theory

This theory was By – Friedman (1956)
As per this Approach – demand for money is treated as demand for capital assets
 Demand for money is affected by same factor as demand for any other asset such as
 Permanent income
 Relative return for assets (incorporates risk)
 Demand for money is determined by permanent income and not current income
 4 Determinant for demand for money
 1. Function of total wealth =
It includes average return on 5 assets classes-money, bonds, equity, physical capital and human capital
 2. Positively related to price level
 3. Inversely related to opportunity cost of money holding
 4. Influenced by inflation

 3. Demand for Money as Behaviour towards Risk

This theory was given By - James Tobin
 Preference: Emphasizes individual preference for more wealth and balance between non interest earning
assets and investments
 Portfolio: Individuals diversifies their portfolios by holding a balanced combination of safe and risky assets
 Risk: individual’s behavior shows risk aversion , which means they prefer less risk to more risk
 Balance: People prefer mix portfolio of money, bonds and shares with each person opting for a little
different balance between risk and return
Tobin's Liquidity Preference Function
Function  Tobin's liquidity preference function links interest rate and money demand
Investment  Higher bond interest leads to higher investment and less cash
Demand  Increased interest rate reduces money demand and increases bond investments
Slope  Depicts downward sloping demand function for money against interest rate
Observation  As bond interest rates decline, the demand for money in portfolios rises
Conclusion  Interest rate impacts money demand elasticity
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CHAPTER – 8 : Money Market

UNIT-2 : The concept of Money Supply

• “Money Supply” Total quantity of money available with the people in economy
• Economic stability requires maintaining money supply at an optimal level to accurate estimation
• “Public” means all economic units except producers of money i.e. banking system and govt.
• Banking system comprises of RBI and banks
• Inter-bank deposits, holding by government and banking system not included in standard
measure of money supply.

◼ Rationale of Measuring Money Supply

• Facilitate analysis of monetary development which further helps understand cause of money
growth
• Central banks worldwide use monetary policies to stabilize price level and GDP growth by
managing supply of money

◼ Sources of Money Supply

Central Bank (CB)
Money CB decision determines its supply in economy
Currency can be issued by CB like fiat money
Source Primary source of money supply and can issue high powered money which is
source of all other forms of money
Fiat money Issued by CB and backed by supporting reserves and value guaranteed by govt.
Gold and Forex CB can issue currency to any extent keeping only its certain minimum amount,
Reserve called 'Minimum Reserve System'

Banking System
Policies Response of commercial banks to policies of central banks determines supply
of money.
Credit Total money supply is determined by credit created by commercial banks
CBDC's Central Bank digital currency (CBDC's) are emerging as digital and new forms
of currencies i.e RBI is exploring CBDC's. eg- digital rupee
Crypto Currency Not considered as money and legal tender by RBI as it face regulatory uncertainty
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◼ Measurement Money Supply

• Measurement of money is difficult due to different types of money and vary from country to
country, time to time and purpose to purpose
• A range of monetary and liquidity measures are compiled by RBI
July 1935 • RBI compiling and disseminating monetary statistics

Till 1967- 68 • narrow measure of money supply

• currency + demand deposits

From 1967-68 • Broader measure of money supply

Broader • aggregate monetary resources

April 1977 • recommended by second working group of money supply (SWG)

• M1, M2, M3, M4 published
M 1, M 2, M 3, M 4
M1 = Currency (notes + coins) with the people+ demand deposits with banking system(CASA) + other
deposits with RBI
M2 = M1 + savings deposits with Post Office saving banks
M3 = M1 + Time deposits with banking system
M4 = M3 + deposits with Post Office saving organisation (excluding national savings certificate)

Determinants of Money Supply

Two Alternative • Exogenous – Determined by Central bank

Theories • Endogenous – affected by economic activities

Current • Money multiplier approach

Explanation • Focus on money stock and money supply in terms of monetary space

Monetary Base • Currency in circulation + bank reserve

Conclusion • Total Supply of nominal money in determined by joint behavior of central

bank, commercial banks and public

Concept of Money Multiplier

• Money created by Central Bank is high powered money

• Banks create money through loan
• Thus ₹ 1 increase in monetary base result in now more than ₹ 1 increase in supply of money
• This increase in money supply is money multiplier
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M=C+D M = m × MB M = Money Supply

C = Currency
𝐌𝐨𝐧𝐞𝐲 𝐒𝐮𝐩𝐩𝐥𝐲(𝐌) D = Deposit
Money Multiplier(m) =
𝐌𝐨𝐧𝐞𝐲 𝐁𝐚𝐬𝐞 (𝐌𝐁)
m = Multiplier
MB = Monetary base

◼ If the following 2 Assumptions are satisfied then,

1
money Multiplier =
Required Reserve Ratio (R)

1. Banks never hold excess revenue

2. Individuals and non-bank corporation never hold currency means all money is deposited into
banks

◼ Money Multiplier Approach – Supply of Money

By – Milton Friedman and Anna Schwartz in 1963
Factors determining money supply –
• Stock high powered money (H)
• Reserve ratio (Reserve / Deposit)
• Currency to deposit ratio (currency / deposit)
The Behavior of the Central Bank

Supply • Reflected in nominal high-powered money supply

Multiplier • Money stock determined by multiplier
Control • Monetary base is controlled by authority/RBI
Assumption • Constant behavior of public and banks
Relationship • Nominal money supply is directly proportional to high-powered money

The Behavior of the Commercial Bank

Influence Reserve ratio, lending and money supply

Multiplier Smaller reserve ratio, higher money multiplier
Excess reserve (ER) It determine money supply (ER = TR – RR)
Opportunity cost Excess reserves incur opportunity cost, influencing bank on interest rate
changes
Interest Interest rate impacts reserve ratio (higher rates lower excess reserves)
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◼ The Behaviour of Public

• Demand deposits undergo multiple expansion, currency doesn't, reducing overall multiple
expansion and money multiplier when deposit convert to currency
• Currency deposit ratio indicates the presence of banking habits, influenced by economic
activity, financial sophistication, access of financial services
• Smaller currency deposit ratio larger the multiplier (high production of high powered money)
• Time deposit - demand deposit ratio (TD/DD), higher ratio means more free reserve enabling
large deposits and monetary expansion
• Money multiplier is determined by
▪ reserve ratio (r)
▪ excess reserve ratio (e)
▪ currency ratio (c)
• Money supply depends on
▪ high power money (H)
▪ money multiplier (m)
▪ varying directly with change in MB, inversely with C and RR
1+𝐜 1+𝐜
In case of excess reserve m = Money Supply (M) = ×H
𝐜+𝐫+𝐞 𝐫+𝐞+𝐜
• Money multiplier is a function of
▪ Currency ratio (set by depositors, depends on public behaviour)
▪ Excess reserve ratio (set by bankers)
▪ Required reserve ratio (set by central bank)

◼ Monetary Policy and Money Supply

• Central Bank stimulate economy through infusing liquidity into system
• Open market operation, e.g: purchase of government securities injects high powered money
into system
𝟏
∆ Money Supply = × ∆ reserve
𝐑
• Effect of open market sale is very similar to open market purchase but in opposite direction
• Money multiplier = 0, when invest rate are too low, Bank hold newly injected reserves as
excess reserve with no risk

◼ Effects of Govt. Expenditure on Money Supply

• Govt facing cash balance shortage can use ways and means advances (WMA) and overdraft
(OD) facilities
• Under WHA/OD, RBI grants excess reserve to govt.
• This happens when govt. incurs expenditure
▪ Dr. - govt. balances with RBI
▪ Cr. - receivers (eg- Salary ac. of govt. employees)
• Excess reserve leads to money supply through multiplier process

◼ Credit Multiplier
• Commercial banks create money by lending out excess reserves.
1
Credit Multiplier =
Required Reserve Ratio
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CHAPTER – 8 : Money Market

UNIT-3 : Monetary Policy

• RBI manages economic fluctuations like inflation to maintain price stability through
adjustments in money supply (monetary policy)
• open market operations are done through buying and selling security in open market
• OMO (open market operations) impact short term interest rates, influencing long term
interest rates
Lowering rates eases monetary policy raising rates tightens monetary policy

◼ Monetary Policy - Framework

Basic components
Objectives of Monetary policy Analytics of Monetary Policy Operating procedures

◼ 1. Objectives
• RBI act 1934:
▪ Regulating issue of notes and keeping reserves for monetary stability
▪ operating currency and credit system

◼ Primary objectives (developing countries)

▪ Maintenance of economic growth
▪ adequate flow of credit to productive sectors
▪ sustaining a moderate structure of interest rate to encourage investments
▪ creation of effective market for govt. securities
• The primary objective is to maintain a balance between price stability and economic growth.

◼ 2. Analysis / Transmission
• The Reserve Bank's monetary policy changes impact economic activity and inflation through
transmission.
• Stages of transmission
▪ changes to monetary policy affecting interest rate
▪ changes to interest rates affecting economic activity and inflation
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◼ Channels of Transmission
(a) Savings and investment channel
Interest Lower interest rates encourage spending over savings
Loans Reduced loan rates stimulate borrowing and increase demand for assets
Investment Lower borrowing costs promote business investment in capital goods, boosting
product demand

(b) Cash flow channel

Impact Monetary policy affects interest rates, influencing spending decisions
Lending Lower rates decrease interest payments, freeing cash for spending
Income Lower rates reduce income from deposits, restricting spending
Economy Lower rates spending in economy

(c) Asset price and wealth channel

Channel Impacts consumption and investment, affecting borrowing and spending
Interest Lower rates support asset prices and elevate future income
Equity Higher asset prices increase equity, easing borrowing
Wealth wealth boost utilization and investment

(d) Exchange rate channel

RBI Lowers cash rate when India's interest rates are below global rates
Investment Lower returns on Indian assets demand
Inflation Lower rates make foreign goods costlier, potentially causing inflation

◼ 3. Operating Procedure and Instruments

(a) Quantitative Tools
Reserve Ratio RBI sets a percentage of cash reserve that banks have to keep aside. Types:
Reserve Ratio
• Cash Reserve Ratio (CRR) - portion of cash set aside by RBI. Cannot lend nor
earn interest on CRR
• Statutory Liquidity Ratio (SLR) - portion of liquid assets (gold or RBI securities).
Set aside by bankers as per RBI can earn interest but its low
Open Market RBI controls money supply through buying and selling govt, securities in open market
Operations • RBI sells reduces liquidity in market
(OMO • RBI buys increases liquidity in market
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(b) Qualitative Tools

Margin Requirement • Difference between value of collateral and amount of loan
Moral Suasion • RBI convinces banks to invest in govt. securities through persuasion
Selective credit control • Controlling credit by not lending to certain industries

(c) Market Stabilization Scheme (MSS)

Policy Rates • Bank Rates: Interest rate at which RBI lend long term loan to banks
• But, RBI presently uses liquidity adjustment facilities (LAF) - Repo
rate
• RBI has set penalties for defaulter bank in non-maintenance of CRR
and SLR
Liquidity Adjustment • Repo rate: Banks borrows form RBI,
Facilities (LAF) • short term against repurchase agreement
• Reverse Repo Rates : RBI pays to banks to keep additional funds in
RBI
• Reverse Repo Rates = repo rate -1
Marginal Standing • MSF is panel rate at which Central Bank lends money to banks over
Facilities Rates rate available under Rep policy
MSF rate = Repo rate + 1