me class 06-07

8/6/2019 ME Class 06-07

http://slidepdf.com/reader/full/me-class-06-07 1/54

MoneyMoney MarketMarket(Money and Banking)(Money and Banking)

T.J. Joseph

8/6/2019 ME Class 06-07


22

What is Money?A financial asset with the following functions:

Medium of exchange:

An asset that individuals acquire for the purpose of

trading rather than for their own consumption.

A store of value:

Means of holding purchasing power over time

A unit of account:

Measure used to set prices and make economiccalculations

8/6/2019 ME Class 06-07


W hat is money?

Money is anythingthat serves as acommonly accepted

medium of exchange

Most liquid CurrencyTransaction deposits

Very liquid

Saving depositsShort-term securitiesMoney-market funds

Less liquid Long-term bondsEquitiesReal assets

Money and IncomeW

hat we earn is income,not moneyMoney is used to pay theincome

8/6/2019 ME Class 06-07


Money SupplyN

arrow (Transactions) Money (M1) =Coins and paper currency + Demand Deposits (orCheckable Deposit), Traveler s Checks, etc.( Other deposits with RBI (= deposits of UTI, IDBI etc; deposits of foreign

central banks/governments etc.) are also a part of M1; statistically very small)

Broad Money (M3) = M1 + time deposits with banks(Money supply in India usually refers to M3)

Also:

M2 ( N ear-Money) = M1 + savings deposits of post officesavings bank

M4 = M3 + total deposits with post office savings banks

8/6/2019 ME Class 06-07


55

53%

46%

1%

M1: R 1253184 cr r , Ma rc 2009 Curr c wi ublic D m and depos i s

µOthe r¶ depos its wi th the RBI

8/6/2019 ME Class 06-07


66

14%

12%

74%

0%

M3: Rs 4764019 rores, Mar h 2009Cu rren y with the p ub li Demand depositsTime deposits µ ther¶ deposits with the R I

8/6/2019 ME Class 06-07


Who Determines Money S u pply?Central Bank (RBI):

Determines the monetary base (also known asreserve money, base money, high powered money

etc.) by fixing the cash reserve ratio, bank rate, etc .Commercial Banks:

Create money through multiple expansion of bank

deposits based on cash reserves ( credit money )General Public:

Through transactions/exchange of money

8/6/2019 ME Class 06-07


Central ankCentral Bank (Reserve Bank of India, Federal Reserve

System in USA) oversees and regulates the banking systemand controls the money supply by determining themonetary base

Three primary functions of the Central Bank:1) Regulates banks to ensure they follow the laws intended

to promote safe and sound banking practices.

2) Acts as a banker s bank, making loans to banks and as alender of last resort.

3) Conducts monetary policy by controlling the moneysupply

8/6/2019 ME Class 06-07


Banking and Supply of Money

The Process of Deposit Creation

Commercial Banks are important source of money

supply

The money they supply is called Credit money

Banks receive deposits from the public

8/6/2019 ME Class 06-07


Banking and Supply of Money

Primary Deposits

i) Savings deposited for the sake of safety

ii) Payment received from the central bank for saleof govt. bond

iii) Payment received from abroad and depositedwith the bank

iv) For the convenience in receiving and makingpayments

8/6/2019 ME Class 06-07


Deposit CreationThe process of credit creation or deposit creation begins

with banks lending money out of primary depositsStatutory Reserve Requirements: Portion of primary depositsto be maintained either as (i) Cash Reserve (CRR)with theCentral Bank, or (ii) excess reserve (Statutory Liquidity

Ratio (SLR)) to meet the cash demand by the depositorsDeposit Creation in a Single Bank System

Assume:

There is a single bank

Accepts only demand deposits

SRR is 20% (CRR of 5% and SLR of 15%)

Assets of the bank are CRs and loans & advances

8/6/2019 ME Class 06-07


Suppose an individual A deposits Rs.1000 with the bank

All deposits with the bank are its liability

The change in the balance sheet of bank is given as:

The bank will lend the Rs.800 other than the reserverequirements

Suppose an individual, B borrow this money. The bank mayhandover the entire Rs.800 to B or open an account in his

name and credit the amount to that account

L ia b ilities Amo u nt Assets Amo u nt

A¶s deposit 1000 SRR 200

L oans & Investments 8 00

Total 1000 Total 1000

8/6/2019 ME Class 06-07


Suppose B keeps the money safe in the bank and to makepayments by cheques whenever he needs

Now, bank s deposits increase by Rs.800 and SRR is Rs.160(20% of 800). Now,

Note, the bank has excess cash reserves of Rs.640 now

The process of borrowing and lending repeated again.


A¶s deposit 1000 SRR ( 200+160) 360B¶s deposit 8 00 L oan to B 800

Exc ess c ash reserves 640


8/6/2019 ME Class 06-07


Suppose the bank lends Rs.640 to another individual, C, andcredits the money to his account

The balance sheet of the bank now is:

This process of borrowing and lending is called the processof credit creation or the process of deposit creation


A¶s deposit 1000 SRR ( 200+160+12 8) 488

B¶s deposit 8 00 L oan to B 800C¶s deposit 640 L oan to C 640

Exc ess c ash reserves 5 12


8/6/2019 ME Class 06-07


This process of deposit and credit creation continues until theexcess cash reserve is reduced to zero, provided no otherprimary deposits are made

Note that a primary deposit of Rs.1000 leads to the creation of atotal deposit of Rs.5000.

Thus, the deposit multiplier equals 5


A¶s deposit 1000 SRR ( 200+160+12 8) 488

B¶s deposit 8 00 L oan to B 800

C¶s deposit 640 L oan to C 640------ ----- ------ -----

------ ----- ------ -----

nth deposit 000 Exc ess c ash reserves 000

Total 5 000 Total 5 000

8/6/2019 ME Class 06-07


8/6/2019 ME Class 06-07


Enabling factors

The process of multiple expansion deposits has beenpossible because that what one bank losses is anotherbank gains

Banks are able to keep only a fraction of the deposits incash why?

(i) No depositor withdraws full amount of his deposit

(ii) W hen depositors draws cheques on their accounts it isnot necessary that banks pass out cash to that extent

Thus, there are two types of bank deposits Primary deposit customers deposit money

Secondary deposits through the process of lending

8/6/2019 ME Class 06-07


Limits on deposit creation

Banks do not have infinite capacity to create depositsbecause of three limitations

(i) The amount of cash that banks have to maintain againstthe deposits (with the central bank and also to meet therequirements of depositors)

(ii) Cash drain or cash leakage. This depends on how

widespread the use of cheques in the economy is.(iii) Banks inability to find borrowers

8/6/2019 ME Class 06-07


8/6/2019 ME Class 06-07


Money Multiplier Approach

The monetary liabilities of the RBI plus Government moneyis known as High Powered Money (H ), also called ReserveMoney or Monetary Base

Therefore, H = currency with the public ( C ) + Reserves ( R) +Other deposits with the RBI

Neglecting other deposits with the RBI , H = C + R

8/6/2019 ME Class 06-07


The monetary base is the sum of currency in circulation andcash reserves of banks (cash in vaults plus deposits with RBI)

It is different from the money supply, bank deposits pluscurrency in circulation. Each rupee of bank reserves backsseveral rupees of bank deposits, making the money supplylarger than the monetary base.

Money Multiplier

The money multiplieris the ratio of the

money supply to themonetary base.

8/6/2019 ME Class 06-07


8/6/2019 ME Class 06-07


Money Multiplier Approach

Now, Money Multiplier, m = M s / H Suppose Ms = M1 = C + DD

W here, C = currency in circulationDD = demand deposits

Reserves, R = r.DD,where, reserve ratio, r = R / DD

Now, m = M s / H = (C+DD) / (C+R)

Suppose Ms = M3 = C + DD + TDW here TD = time deposits

Now, m = M 3 / H = (C+DD+TD) / (C+R)

8/6/2019 ME Class 06-07


Role of General Public in Money SupplyHow to know money supply over a period of time?

Velocity of circulation of money the number of timesmoney changes hands

Therefore, supply of money over a period of time = theamount of money * velocity of circulation

For practical point, we divide the national income bymoney supply to obtain the income velocity of circulationof money

Suppose, in 2008-09 NI at current prices was Rs.36535crores and the money supply was Rs.7558 crorestherefore, income velocity is 4.83

8/6/2019 ME Class 06-07


Equation of exchange

During any period the total value of transactions must be thesame as the total value of money exchanged

Total value of transactions equal total goods and servicestraded ( T ) multiplied by their average price ( P )

Total value of money exchanged equal the amount of money(M) multiplied by the velocity of circulation ( V ).

Equating what is paid and what is received,

MV = PT equation of exchangeReplacing T with real NI, Y , we get

MV = PY

8/6/2019 ME Class 06-07


Money S u pply

How does money supply affect GDP? The value of the GDP is nothing but the sum total of all thetransactions (given by the velocity of money) over a periodof time

GDP, therefore, depends on the stock of money multipliedby the speed with which money changes hands

As the stock of money increases, more goods and services

will be exchanged and the GDP will rise (a stimulative role)If the economy is already operating in fullcapacity, increase in money supply will lead to inflation

8/6/2019 ME Class 06-07


Money Demand

Money demand is determined by several factors.

According to the theory of liquidity preference , one of

the most important factors is the interest rate.People choose to hold money because money can beused to buy other goods and services.

8/6/2019 ME Class 06-07


Demand for Money

Reasons for Money Demand (1) Transactions Demand for Money

That is, to buy goods and services

It is a positive function of income (GDP) Higher incomehigher the demand for money to buy goods and services

But it is also a negative function of interest rate

(2) Precautionary Demand for Money

Hold money to meet unforeseen emergencies

It is also a positive function of income and a negativefunction of interest rate

8/6/2019 ME Class 06-07


Demand for Money

(3) Speculative Demand for MoneyHolding money to make capital gains or avoid capital losses

It depends on the people s expectation about bond prices

If the current bond prices are low and expected to rise,people will hold less money and buy more bonds(speculative demand for money is low) and vice versa.

ConclusionThe demand for money is an increasing function of incomeand a decreasing function of interest rate

8/6/2019 ME Class 06-07


Interest Rates: The Price of Money

Interest is the payment made for the use of money

or the price paid to borrow money

Costs of Holding Money

The opportunity cost of holding money is the interest thatyou would have earned if you invested it

An increase in the interest rate raises the opportunitycost of holding money.

As a result, the quantity of money demanded is reduced.

8/6/2019 ME Class 06-07


Interest Rates: The Price of Money

N ominal and Real Interest RatesN ominal interest rate measures the yield in rupees peryear per rupee invested (it is the money value)

It does not take into account the changes in the pricesor inflation factor

Real interest rate is corrected for inflation

It is calculated as the nominal interest rate minus rateof inflation

E.g.: Nominal interest rate is 8%, Inflation rate is 3%:therefore, the Real interest rate is 8 3 = 5% per year

8/6/2019 ME Class 06-07


Equilibrium in the Money Market

Quantity of Money

InterestRate

0

Moneydemand

Quantity fixedby the RBI

Moneysupply

r 2

Md 2

r 1

Md 1

Equilibriuminterest rate

8/6/2019 ME Class 06-07


Changes in the Money S u pplyThe RBI can shift the aggregate demand curve when itchanges monetary policy.

An increase in the money supply shifts the money supplycurve to the right.

W ithout a change in the money demand curve, theinterest rate falls.

Falling interest rates increase the quantity of goods andservices demanded.

8/6/2019 ME Class 06-07


Y 2

AD2

3. whichincreases thequantity of goodsand servicesdemanded at agiven price level.

1. W henthe RBI

increasesthe moneysupply

MS2

A Monetary Injection...A Monetary Injection...

Y 1

P

Quantityof Output

0

PriceLevel

Aggregatedemand, AD1

(a) The Money Market

Quantityof Money

0

Moneysupply, MS1

r 1

InterestRate

(b) The Aggregate-Demand Curve

r 2

2. the equilibrium

interest rate falls

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

8/6/2019 ME Class 06-07


MONETARY POLICYMONETARY POLICY

8/6/2019 ME Class 06-07


Monetary Policy

How does a monetary authority decide on when toexpand or contract credit and by how much?

Decision based on the overall objectives of themonetary policy

8/6/2019 ME Class 06-07


Meaning of Monetary Policy

Monetary policy is essentially a programme of actionundertaken by the monetary authorities, generally thecentral bank, to control and regulate the supply of money with the public and the flow of credit with a view to achieving predetermined macroeconomic goals

The objectives of monetary policy are the same as of macroeconomic policy price stability, currency stability,

financial stability, growth in employment and income

8/6/2019 ME Class 06-07


Money S u pply

The money supply is controlled by the RBI through:

Changing the reserve requirements

Changing the bank rate

Open-market operations

Thus the quantity of money supplied does notdepend on the interest rate and is vertical.

8/6/2019 ME Class 06-07


Instruments of Monetary Policy

Credit Control by the Central BankInstruments of credit control

Broadly categorized into two:

General instruments are intended to regulate the totalvolume of credit (quantitative)

Include (1) bank rate, (2) open market operations,

(3) power to vary the reserve requirements Selective instruments to regulate the purpose for which

commercial banks generated credit (qualitative)

8/6/2019 ME Class 06-07


Variable Reserve RatiosBanks are required to maintain a percentage of theirdeposits in the form of balances with the RBI, known aslegal reserve requirement (statutory reserve requirement)

RBI has the power to vary this ratio and used as an

instrument of credit controlAn increase in reserve requirement ratio will reduce thereserves for lending by the banks

A lowering of the reserve ratio will enable the banks toexpand credit

The most easiest way to control credit

8/6/2019 ME Class 06-07


Bank Rate

The minimum rate at which the central bank of a countryprovided financial assistance to commercial banks

By raising or lowering bank rate, the central bank canreduce or expand credit granted by banks

Currently bank rate in India is 6.0%

8/6/2019 ME Class 06-07


Bank Rate

How bank rate works? bank rate cost of borrowing by commercial banks

from the central bank in lending rate of commercialbanks less borrowing

Adverse effect on the level of production and prices

Usually used during inflationary situation

Similarly, a fall in bank rate lower the lending rates of CBsand lead to expansion of bank credit and may raiseincome and output

8/6/2019 ME Class 06-07


Conditions for successful working of bank rate

A well organized money market in order to have impacton other rates in the market

Reactions of borrowers to change in the lending rates

A fall in output may coexist with a rise in price

Customers assessment of the economic situation. If thebusiness conditions are not favorable lowering of lending

rate may not attract much borrowers

8/6/2019 ME Class 06-07


Bank Rate in India

8/6/2019 ME Class 06-07


P oli c y Rates(www.r b i.org.in, 07/06/2010)

Bank rate 6 %

Repo rate 5. 25 %

Reverse repo rate 3. 75 %

Repo (from the perspe c tive of the seller of a se cu rity ) or Reverserepo (from the perspe c tive of the bu yer of a se cu rity ) is aRep u r c hase agreement in whi c h two parties agree to sell and

rep u r c hase a se cu rity on an agreed date at a predetermined pri c e.When b anks sell se cu rities, repo rate is appli c a b le; when b anks bu yse cu rities to park s u rpl u s f u nds, reverse repo rate is appli c a b le.

8/6/2019 ME Class 06-07


Reserve Ratios(www.r b i.org.in, 07/06/2010)

Cash Reserve ratio 6 %

Stat u tory L iq u idity ratio 25 %

8/6/2019 ME Class 06-07


Open Market OperationsPrimary instrument of credit control in developed markets

Involve the purchase and sale of securities by the centralbank

The purchase of securities by a central bank leads to anincrease in the bank reserves

This leads to a multiple expansion of credit and deposits

On the other hand sale of securities by the central bankwill reduce bank reserves and lead to multiple contractionof credit

This is not used as an instrument of credit control inIndia, because this market is very narrow in India

8/6/2019 ME Class 06-07


Selective Credit Controls

Purpose is to regulate the flow of credit for financingspecific activities

RBI encourages the flow of credit to agriculture and toother sectors like export

For borrowings of CBs to refinance such operations RBIcharges a lower interest rate than the bank rate

The ultimate objective is to prevent a rise in the price of

these commodities with the help of bank creditSelective credit controls have been operation in Indiaagainst commodities like foodgrains, oilseeds, cotton, etc.

8/6/2019 ME Class 06-07


The Effects of Money on Output and

PricesTransmission Mechanism of Monetary Policy

Suppose RBI is concerned about inflation and has decidedto slow down the economy

Step 1: Suppose RBI reduces reserves with the banksthrough any of its credit control activity

Step 2: Reduction in bank reserves result in a multiplecontraction in deposit or credit creation, therebyreducing the money supply

8/6/2019 ME Class 06-07


The Effects of Money on Output andPrices

Step 3: Reduction in money supply increases interest ratesand tightens credit conditions, and lowers the value of people s assets

Step 4: W ith higher interest rates and lower wealth,investment falls. It may raise the exchange rate of thecurrency, depressing net exports

Step 5: Tight money leads to reduced aggregate demand,reduces income, output, jobs and inflation

8/6/2019 ME Class 06-07


In short

In a fully employed economy, the higher money supplywould be chasing the same amount of output and wouldtherefore mainly end up raising prices

That is, in the long run, prices and wages are moreflexible, and money supply changes tend to have a largerimpact on prices and a smaller impact on output

8/6/2019 ME Class 06-07


Inflation and interest rate

If both lenders and borrowers expect inflation over the term of a loan . .

Lenders will demand a higher rate because the money

repaid will have less purchasing power than the moneythey lend now

Borrowers will willingly pay a higher rate because theyknow it will be easier to earn the needed money laterthan it is now

8/6/2019 ME Class 06-07


V ideoshttp: //www.money c ontrol. c om /video /e c onomy /monetary -tightening -may -not -help -tame -inflatione c o -advisor_ 43461 8.html

http: //e c onomi c times.indiatimes. c om /Chetan -Ahya -

reviews -RBI-monetary -poli c y /videoshow /5162691 .c ms

http: //e c onomi c times.indiatimes. c om /Need -to -c oordinate -monetary -and -fis c al -poli c y-D-

S ubb arao /videoshow /4893491 .c ms

8/6/2019 ME Class 06-07


Thank Yo uThank Yo u

me class 06-07

Documents