Demand for Money, Demand for Money,

Supply of Money Supply of Money and Monetary and Monetary

PolicyPolicy

Dr. Shylajan, C.SDr. Shylajan, C.S

Topics of DiscussionTopics of Discussion Money SupplyMoney Supply Money Stock MeasuresMoney Stock Measures The Money Market: DD & SSThe Money Market: DD & SS The Demand for Money: Keynesian The Demand for Money: Keynesian

TheoryTheory Determination of Interest Rates: Determination of Interest Rates:

Classical vs Keynesian TheoryClassical vs Keynesian Theory Monitory Transmission Mechanism Monitory Transmission Mechanism

(Change in Monetary Policy and Impacts (Change in Monetary Policy and Impacts on Interest Rate, Consumption, on Interest Rate, Consumption, Investment, AD and GDP)Investment, AD and GDP)

Nominal Vs Real Interest RatesNominal Vs Real Interest Rates

Money Supply-How Money Supply-How is it definedis it defined Money is a medium of exchange. Money is a medium of exchange. It is what we use to make It is what we use to make

paymentspayments What is that we use to make What is that we use to make

payments?payments?

Currency and Currency and

Chequeable deposits with Chequeable deposits with banksbanks

Components of Components of Money SupplyMoney Supply

Narrow Money (M1)Narrow Money (M1) Broad Money (M3)Broad Money (M3) M1 = Currency with public + saving M1 = Currency with public + saving

(demand) deposits with banks + (demand) deposits with banks + “other deposist” with RBI“other deposist” with RBI

M3 = M1 + time (fixed) deposits with M3 = M1 + time (fixed) deposits with banksbanks

Why do we Demand Why do we Demand MoneyMoney Role of Money in Classical Theory: Role of Money in Classical Theory:

Does not influence price, real Does not influence price, real interest rate and real income.interest rate and real income.

Quantity theory of money: MV=PTQuantity theory of money: MV=PT Keynesian Theory: 3 motivesKeynesian Theory: 3 motives

Transaction demand for Transaction demand for moneymoney

Precautionary demand for Precautionary demand for moneymoney

Speculative Demand for Speculative Demand for MoneyMoney

Why do we Demand Why do we Demand MoneyMoneyTransaction demand for moneyTransaction demand for money

Positive function of incomePositive function of income Negative function of interest rateNegative function of interest rate

Precautionary demand for moneyPrecautionary demand for money

Positive function of incomePositive function of income Negative function of interest rateNegative function of interest rate

Why do we Demand Why do we Demand MoneyMoney Speculative Demand for MoneySpeculative Demand for Money

Expected change in interest ratesExpected change in interest rates In short, demand for money is a In short, demand for money is a

negative function of interest rate negative function of interest rate and positive function of incomeand positive function of income

Stability of demand for money is Stability of demand for money is the key to proper conduct of the key to proper conduct of monetary policymonetary policy

Md=kY+f(i)Md=kY+f(i)

The Money Market and The Money Market and Determination of Determination of Equilibrium Rate of InterestEquilibrium Rate of Interest

Interest rate: cost of borrowing moneyInterest rate: cost of borrowing money

How does the interest rate determined? How does the interest rate determined? (both in classical and Keynesian theory)(both in classical and Keynesian theory)

Supply of money and demand for moneySupply of money and demand for money Interest rate is set by the intersection of DD Interest rate is set by the intersection of DD

for and SS of moneyfor and SS of money Md=MsMd=Ms

Determination of Determination of Interest Rate- Interest Rate- GraphicallyGraphically Demand for money is inversely Demand for money is inversely

related to interest raterelated to interest rate

Supply of money is given Supply of money is given (determined by Monetary (determined by Monetary authority, RBI for instance)authority, RBI for instance)

Interest RatesInterest Rates

Consumers and investors rely on Consumers and investors rely on money for purchase of goods and money for purchase of goods and services. services.

Monetary authority can augment Monetary authority can augment AD or reduce AD AD or reduce AD by changing by changing money supply and thereby money supply and thereby interest rates.interest rates.

Change in Monetary Change in Monetary PolicyPolicy Monetary authority may follow a Monetary authority may follow a

Easy monetary policy or Easy monetary policy or Tight monetary policyTight monetary policy

What is easy and tight monetary policy?What is easy and tight monetary policy?

Easy Monetary Policy ……money supply Easy Monetary Policy ……money supply growth increases…..interest rate declinegrowth increases…..interest rate decline

Change in Monetary Change in Monetary PolicyPolicy

Then what happens to demand Then what happens to demand for money?for money?

Demand for money will increase Demand for money will increase andand

Then spending on goods and Then spending on goods and services increasesservices increases

Change in Monetary Change in Monetary PolicyPolicy Tight Monetary Policy…..money Tight Monetary Policy…..money

supply growth falls…..interest rate supply growth falls…..interest rate increasesincreases

Then demand for money will fall…..so Then demand for money will fall…..so spending on goods and services fallsspending on goods and services falls

What kind of monetary policy RBI is What kind of monetary policy RBI is following now? following now?

Change in Monetary Change in Monetary Policy and Impacts - Policy and Impacts - Graphically Graphically AD-AS frameworkAD-AS framework

Nominal Vs Real Nominal Vs Real Interest RatesInterest Rates Real interest rate = Nominal Real interest rate = Nominal

interest rate minus rate of interest rate minus rate of inflationinflation

12% nominal interest rate – 3% 12% nominal interest rate – 3% inflation rate =9 % real interest inflation rate =9 % real interest raterate

The Money Supply The Money Supply ProcessProcess What causes change in money supply?What causes change in money supply?

M = C + DM = C + D Where M is money stock, C is currency Where M is money stock, C is currency

with public and D is bank depositswith public and D is bank deposits Three groups influence money supply Three groups influence money supply

growthgrowth1. Central bank1. Central bank2.Commercial Bank2.Commercial Bank3. Public3. Public

Money MultiplierMoney Multiplier

Money multiplier (m) = M3/HMoney multiplier (m) = M3/H M3 = Currency with Public + DepositsM3 = Currency with Public + Deposits High powered money = Currency + High powered money = Currency +

ReservesReserves

Where m is money multiplierWhere m is money multiplier

M3 is total money supplyM3 is total money supply

Control of Money Control of Money Supply by RBISupply by RBI

Instruments of ControlInstruments of Control

Changing Reserve Requirements Changing Reserve Requirements (CRR, for instance)(CRR, for instance)

Changing the Bank RateChanging the Bank Rate

Direct Credit ControlsDirect Credit Controls

Monetary Policy Monetary Policy Transmission Transmission MechanismMechanism Money supply changeMoney supply change Effect on interest rate “r”Effect on interest rate “r” Impact on business spendingImpact on business spending Impact on consumer Impact on consumer

spendingspending Impact on Output or GDPImpact on Output or GDP

Monetary Policy in Monetary Policy in the AD- AS the AD- AS FrameworkFramework

Two CasesTwo Cases

The case of increase in AD where The case of increase in AD where potential output is not achievedpotential output is not achieved

The case of increase in AD and its The case of increase in AD and its impact on output and price when impact on output and price when potential output is reachedpotential output is reached

Graphical approachGraphical approach

Monetary Policy in Monetary Policy in IndiaIndia Changes in major Monetary Policy Changes in major Monetary Policy

Measures:Measures:

Bank RateBank Rate Cash Reserve Ratio (CRR)Cash Reserve Ratio (CRR) Statutory Liquidity Ratio (SLR)Statutory Liquidity Ratio (SLR)

Monetary Policy in Monetary Policy in India…India… Bank RateBank Rate in 1999: in 1999: 12 %12 % In 2003In 2003 :: 6 %6 % In 2007In 2007 :: 6%6%

CRRCRR in 1991 in 1991 :: 15 %15 % In 2004In 2004 :: 5 %5 % In 2007In 2007 :: 7.50%7.50%

SLR SLR in 1992in 1992 :: 38.5 %38.5 % In 1997In 1997 :: 25 %25 % In 2007In 2007 :: 25 %25 %

SummarySummary