Money and the Monetary System

What is money? Functions of money

Money is the set of all assets that are regularly used to
directly purchase goods and services.
Money serves three main functions:
1. Store of value: Money represents a certain amount of
purchasing power.
2. Medium of exchange: money can be used to purchase
goods and services.
• A barter system is where people directly offer a good or
service for another good or service.

3. Unit of account: money provides a standard unit of

comparison.
 What makes for good money?
There are two basic considerations that make certain money
better than others.
Stability of value:
• Early versions of money generally took the form of a
physical material that was durable and had intrinsic value.
• Money does not need intrinsic value to maintain stability.
Convenience:
• Technology has allowed for the development of more
convenient forms of money.
• For example, paper money is more convenient than gold
coins.
Commodity-backed money versus fiat money
Any form of money that can be legally exchanged into a
fixed amount of an underlying commodity is commodity-
backed money.
• The most common underlying commodity is gold.
Money created by rule, without any commodity backing it,
is fiat money.
• U.S. currency is backed only by the trust that the
government will keep the value of money relatively
constant.
 Measuring money
The money supply is the amount of money available in the
economy.
• The money supply is managed by the Central Bank.
The Central Bank classifies different types of money by their
liquidity.
• The monetary base includes cash and bank reserves,
sometime referred to as hard money. In U.S.
• M1 includes cash plus checking account balances.
• M2 includes M1 plus savings accounts and other financial
instruments.
 Money Aggregates in India
Measure of money supply defined by RBI

 M1: Currency with the public + Deposit money of the

public (Demand deposits with the banking system +
‘Other’ deposits with the RBI).

 M1 is the narrow money

 M2: M1 + Savings deposits with 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).
 Managing the money supply
The central bank is the institution responsible for
managing the nation’s money supply and coordinating the
banking system.
In the U.S., the central bank is the Federal Reserve, which
has been mandated by Congress to conduct monetary
policy to perform two essential functions:
1. Manage the money supply.
2. Act as a lender of last resort.

•Monetary policy refers to the actions made by the central

bank to manage the money supply.
 Managing the money supply
The Fed has a twin or dual mandate:
• Ensuring price stability: Enacting monetary policy that
meets the needs of the economy while keeping prices
constant over time.
• Maintaining full employment: Enacting monetary policy
that keeps the economy strong and stable.
video to watch
• http://www.cc.com/video-clips/2l8p98/the-colbert-report-
fed-s-dead
 Tools of monetary policy
The Fed achieves these mandates by managing the money
supply through three main tools.
1. The reserve requirement is the amount of money banks
must hold in reserve.
2. The discount window is the lending facility that allows
banks to borrow reserves from the Fed.
• The discount rate is the interest rate charged by the Fed for
loans through the discount window.
3. Open-market operations are sales or purchases of
government bonds by the Fed to or from banks on the
open market.
 Tools of monetary policy in India
1. LAF- Repos and Reverse Repos

2. Marginal standing facility

3. Open market operations

4. Reserve requirements

- Cash Reserve Ratio (CRR)

- Statutory Liquidity Ratio (SLR)

5. The discount or bank rate: The interest rate that the RBI
charges on loans it makes to banks.

6. Moral suasion & prudential

 Reserve Requirements

RBI regulations that require banks to hold a minimum

reserve-deposit ratio.

Cash Reserve Ratio (CRR)

CRR is the ratio of a bank’s cash holdings with RBI to its
total deposit liabilities.

Banks hold CRR at the RBI and no regular interest is

earned on the balance held at the RBI.
 Advantages of CRR

If RBI wants to reduce money supply, it increases the CRR

and vice versa.

Good for big changes in ‘Ms’.

Changing the CRR has no cost, it remains the favored

method in India.
– CRR rule does not apply to Regional Rural Banks,
Non Banking Financial Companies (NBFC), Mutual
funds or insurance companies.
 Disadvantages of CRR
An increase in CRR has undesirable side effects on bank profits.
Example: For SBI, a 4% CRR works out more than Rs 50,000 crore
which won’t attract any interest.
A news clip

Cannot obtain small changes in “M”.

Success depends on bank behavior with respect to excess

reserves. Banks with low excess reserves can be in trouble if the
ratio is changed. Cannot change often.
 Statutory Liquidity Ratio (SLR):
Monetary policy tool which indirectly influence MS

SLR refers to the rate at which banks are required to

maintain their reserves in most liquid assets
(government securities).

Through SLR, RBI changes the deposits available for

lending purpose thereby influence MS.

The govt. imposes an obligation on the banks to use a

proportion of cash to buy govt. securities.
 Repos and Reverse Repos

The Liquidity Adjustment Facility (LAF) introduced in

June 2000 emerged as the principal operating
instrument for modulating short-term liquidity.

Consequently, the repo rate (the rate at which banks

borrow funds from the RBI against collateral) and the
reverse repo rate (the rate at which banks place their
funds with the RBI and receive collateral) emerged as
the key instruments for signaling the monetary policy
stance.
Marginal standing facility (MSF)

Marginal standing facility, this is for long term with respect to LAF.
In the case of LAF banks cannot sell Government security to RBI
that is part of bank's SLR quota but it can borrow any amount of
money as long as it has the GOVT securities to sell.
But with MSF banks can sell the Government security from its SLR
quota to RBI but it can maximum borrow up to 2% of its Net
Demand and Time Liabilities (NDTL) outstanding at the end of
second preceding fortnight. .
Suppose repo rate is "r%" then MSF lending rate is always (r+x)
%.
18
 Open-Market Operations

 Increase money supply

– RBI buys bonds
• Open-market purchase

 Reduce money supply

– RBI sells bonds
• Open-market sale
 Open-Market Operations
• Open-market operations, which take place in the “open
market” for bonds, are the standard method central banks use
to change the money stock in modern economies.

• If the central bank buys bonds, this operation is called an

expansionary open market operation because the central bank
increases (expands) the supply of money.

• If the central bank sells bonds, this operation is called a

contractionary open market operation because the central
bank decreases (contracts) the supply of money.
 Advantages of OMO

• OMO are fully under the central bank’s control and can be
undertaken in fine, small, or large quantities.

• Quickly implemented, easily reversed.

 Tool of choice for the RBI

 Influences bank reserves
 Influences RBI funds rate
– Interest rate
– Borrowing among banks
– Of excess reserves at RBI
 The Discount Rate

 The discount rate or bank rate

– Interest rate, RBI
– For loans made to banks
 Bank borrow ‘Discount window’
– Satisfy reserve requirements
 RBI
– Lender of last resort
 Policy Key Rates
Reverse Repo Rate : 6.00%

Policy Repo Rate : 6.25%

Marginal Standing Facility Rate : 6.5%

Bank Rate : 6.5%

CRR : 4%
SLR : 19.5%
The economic effects of monetary policy

The liquidity-preference model The liquidity-preference

model refers to the idea
that the quantity of money
people want to hold is a
function of the interest rate.
• This means the money
demand curve slopes
downward.
• The RBI sets the money
supply, which means the
money supply curve is
set by monetary policy.
 The economic effects of monetary policy
The liquidity-preference model explains how the RBI’s actions
can change interest rates.
Shifts in the money supply curve
• Expansionary
monetary policy results
in a higher quantity of
money and lower
interest rates.
• Contractionary
monetary policy results
in a lower quantity of
money and higher
interest rates.
 The economic effects of monetary policy
The slope of the money demand curve affects the amount of
change in the interest rate.

The more elastic money demand… The more inelastic money demand…
….smaller the effect on interest rates. …greater effect on interest rates.
 The money supply
For each of the following situations, indicate the effect
(increase or decrease) on the money supply and interest
rate.

Change in money
Situation Change in interest rate
supply

The RBI conducts open-market

Blank Blank
bond purchases.

The RBI sells government

Blank Blank
bonds on the open market.
 The money supply Solution
For each of the following situations, indicate the effect
(increase or decrease) on the money supply and interest
rate.

Change in money
Situation Change in interest rate
supply

The RBI conducts open-market

Increase Decrease
bond purchases.

The RBI sells government

Decrease Increase
bonds on the open market.
Impact of Monetary Policy on
Economy
 Tools of monetary policy
These transactions directly impact the money supply.
• Contractionary monetary policy is when money supply is
decreased to lower aggregate demand.
• Expansionary monetary policy is when money supply is
increased to raise aggregate demand.
 Expansionary monetary policy
Expansionary monetary policy Expansionary monetary policy and the AD/AS model

Interest rate, r Price level

LRAS

MS 1 MS 2 SRAS

P2
r1 P1

r2 AD2

Money
demand
AD1
Q1 Q2 Y1 Y2
Quantity of money Real GDP

• During a recession, expansionary • The aggregate demand curve shifts out.

monetary policy decreases the interest • Price and output increase.
rate.
• Cheaper to borrow and less rewarding
to save money.
 Contractionary monetary policy
Contractionary monetary policy Contractionary monetary policy and the AD/AS model
Interest rate, r Price level
LRAS
MS MS SRAS
2 1

P1
r2 P2

r1 AD1

AD2
MD

Q2 Q1 Y2 Y1
Quantity of money Real GDP

• During overheating, contractionary • The aggregate demand curve shifts in.

monetary policy increases the interest • Prices and output decrease.
rate.
• More expensive to borrow and
encourages saving.
Challenges and advantages of monetary policy

Analyzing the use of monetary policy shows how policy can

work in ideal cases, but it is rare for the world to work so
cleanly.
Challenges
• The RBI faces time lags and imperfect information.
• A few months can pass before the RBI’s actions make their
impact.
• Mistiming of monetary policy could make economic conditions
worse.
• Moreover, many high-income countries have found, monetary
policy loses much of its effectiveness at the zero lower bound
Challenges and advantages of monetary policy

Advantages
• The RBI does not have to wait for politicians to come to a
policy consensus.
• The RBI is made up of prominent economic policy-makers.
• It is their job to make sure they fully understand the nuances
of the overall economy.
Money and the Banking System
 video

https://www.youtube.com/watch?
v=iPkJH6BT7dM
 Basic Concepts
100-percent-reserve banking: a system in which banks
hold all deposits as reserves.
Paper money made it possible for banks to create money
through a process called fractional-reserve banking.
The primary way that banks earn money is through lending
a fraction of deposited funds and collecting interest on
those loans.
• Demand deposits are funds held in bank accounts that can
be withdrawn by depositors at any time, without advance
notice.
 Banks and the money-creation process

The reserve ratio is the ratio of the total amount of

demand deposits at the bank to the amount kept as
cash reserves.
• Required reserves is the amount that a bank is
legally required to keep on hand.
• Excess reserves is any additional amount that a
bank chooses to keep beyond the required
reserves.
 Basic Concepts: How Banks Work

• Banks earn profit

• Attract deposits from savers
 Lend to borrowers

 Banks are financial intermediaries

 Reduce transaction costs
 Cope with asymmetric information
 Reduce risk through diversification
 Banks’ Role in the Money Supply

• The money supply equals currency plus

demand (checking account) deposits:
M = C + D

• Since the money supply includes demand

deposits, the banking system plays an
important role.
 SCENARIO 1: No Banks

With no banks,
D = 0 and M = C = Rs100.
SCENARIO 2: 100 Percent Reserve Banking
 Initially C = Rs100, D = Rs 0, M = Rs100.
 Now suppose households deposit the 100 at
“Firstbank.”
• After the deposit,
FIRSTBANK’S
C = ` 0,
balance sheet D = ` 100,
Assets Liabilities M = ` 100.
reserves ` 100 deposits ` 100

100% Reserve Banking has no impact on size of money supply.

 SCENARIO 3: Fractional-Reserve Banking
For a particular bank, a particular amount of deposit creation will
lead to equivalent amount of credit creation plus reserves (here 10%)
Liabilities Assets
Deposit 100 Reserves 10
Advances 90
Total 100 Total 100

The depositor still has 100 in demand deposits, but now the
borrower holds 90 in currency. Therefore, the money supply now
equals 190.

Thus, in a fractional-reserve banking system, banks create money.

 Bank Deposit Multiplier
• Bank A
Liabilities Assets
Deposit 100 Reserves 10
Advances 90
Total 100 Total 100

• Bank B Liabilities Assets

Deposit 90 Reserves 9
Advances 81
Total 90 Total 90
Summary of the Money Creation
Resulting from the RBI’s Purchase of
Rs 100 Government Bond

Bank Increase Increase Increase

in in in
Deposits Advances Reserves
A 100.00 90.00 10.00
B 90.00 81.00 9.00
C 81.00 72.90 8.10
D 72.90 65.61 7.29
E 65.61 59.05 6.56
F 59.05 53.14 5.91
… … …. …
All Banks 1,000.00 1,000.00 100.00
 Banks and the money-creation process
 
The money creation process continues with repeated cycles
of lending and depositing of funds.
The money multiplier is the ratio of money created by the
lending activities of the banking system to the money
created by the central bank:

In a fractional-reserve banking system, banks keep less than

100% of their deposits on reserves.
Finding the total amount of money:
Original deposit = 100
+ Firstbank lending = 90
+ Secondbank lending = 81
+ Thirdbank lending = 72.9
+ other lending…

Total money supply = (1/r )  100

where r = ratio of reserves to deposits

In our example, r = 0.1, so M = 1000

 Banks and the money-creation process
• Total increase in deposits for the banking system
will be = 100 * (1/0.1) = 100 * 10 = 1000
• However, the above conclusion is conditional upon
two assumptions
– All the banks are able to find ready borrowers so that
they can utilize the entire amount of additional
deposits above the reserve amount
– Borrowers are keeping the entire advances in the form
of deposits in bank and do not convert a part of it into
currency
 Reading

Business Standard Oct 16, 2017