topic 5a money in india pgppm

8/3/2019 Topic 5a Money in India PGPPM

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Topic 5a

Money in the

Indian Economy


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Overview

Money in the Indian economy

The Reserve Bank of India and its

functions Fractional reserve banking - how does

it work?

The money multiplier

Tools of Monetary control


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Money in the Indian Economy

Money Stockis the quantity of moneycirculating in the economy.

Different ways of measuring the moneystock in the economy:

M0 = H Reserve/base Money(also called High Powered)

M1 = C + DD + OD Narrow Money

M3 = M1 + TD Broad Money

Where C =Currency DD = Demand (current) deposits

OD =other deposits , TD = Time (Fixed) Deposits


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The most familiar form of money - called narrowmoney - used includes:

Currency

Other Deposits (OD)

Demand Deposits (DD)Rs. 422843 on March 31, 2002 - approx. 4248per capita

Rs. 473581 on March 31, 2003

Rs. 578716 on March 31, 2004

Rs. 646263 on March 31, 2005

is it stock or flow?

Measurement of Money

M1


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Measurement of Money

A broader measure of money than M1,includes: M1 +

Personal Term Deposits

Rs 1498355 on March 31, 2002 of Indiancurrency outstanding

Rs 1717960 on March 31, 2003

Rs. 2005676 on March 31, 2004

Rs. 2253938 on March 31, 2005

is it stock or flow?

M3


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Quick Quiz!

List and describe the fourfunctions of money.


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The Reserve Bank of India

The Reserve Bank Of India (RBI) servesas the nations central bank, which isdesigned to control the quantity of money in

the economy.The RBI is owned by the Indiangovernment, established in 1935 by an Act

of Parliament.

Ref. www.rbi.org.in
http://www.rbi.org.in/http://www.rbi.org.in/


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The RBIs Organization

The RBI is run by its Board of Governorswhich is composed of:

The Governor.

Three Deputy Governors.

All members are appointed by the FinanceMinistry.


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The RBIs Organization

The RBI is controlled by the Govt. of Indiawhich appoints the Board of Directors.

As a last resort the government can issue awritten directive to the Governor with whichhe must comply.

In practice the Reserve Bank of India islargely independent of the governmentis itgood or bad?


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Central Bank Independence

In practice RBI is largely independent of the Government

What about

Japan

U.S.A.

New Zealand

Germany U.K.

Canada

China


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4 Primary Functions of the RBI

Issuecurrency.

Act as a bankers bank, making loans

to other banks and as a lender of lastresort.

Act as bankerto the Government of

India. Control the money supply with

monetary policy.


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Money Supply Changes by the RBI

Open-Market Operations: The primary way inwhich the RBI changes the money supply isdone through the purchase and sale of

Government of India bonds.- To increase the money supply, the RBI buys

government bonds from the public.

- To decrease the money supply, the RBI sellsgovernment bonds to the public.


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Tools of Monetary Control

The RBI has 3 instruments of monetarycontrol:

Open-Market Operations:

Buying and selling bonds.

Changing the Reserve Ratio (CRR, SLR):

Increasing or decreasing the ratio.

Changing the Bank Rate:

The interest rate the RBI charges other banksfor loans.

Ref: RBI Tables -Handout


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Quick Quiz!

How does the RBI increase the supply ofmoney in the economy?


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Overview The functions and measurement of money

The Reserve Bank of India and itsfunctions

Fractional reserve banking - how does itwork?

The money multiplier

Tools of Monetary control


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Banks and The Money Supply

The behaviour of banks can influencethe quantity of demand deposits in theeconomy and therefore, the money

supply.

Fractional Reserve Banking System:The practice of holding a fraction of

money deposited as reserves andlending out the rest.


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Fractional Reserve Banking

Deposits into a bank are recorded as bothassets and liabilities. Deposits that havebeen received but not lent out are called

reserves. The supply of money in the economy is

affected by the amount of deposits that arekept in the bank as reserves and the

amount that is lent out. Loans become anasset to the bank.


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Bank T-Account Example

Assets Liabilities

First National Bank

ReservesRs10.00

LoansRs90.00

DepositsRs100.00

Total AssetsRs100.00

Total LiabilitiesRs100.00


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Bank T-Account Example

A T-Accountillustrates thefinancial position of

a bank that acceptsdeposits, keeps aportion as reservesand lends out therest.

Assets Liabilities

First National Bank

ReservesRs10.00

LoansRs90.00

DepositsRs100.00




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Multiple-Bank Expansion of Money


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Money Creation withFractional-Reserve Banking

When a bank makes a loan (from itsreserves) the money supply increases.

When banks hold only a fraction of depositsin reserve, banks create money.

The creation of money through loans doesnot create any wealth, but allows banks to

charge interest several times on the samebit of wealth.


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The Money Multiplier

When one bank loans money, thatmoney is generally deposited intoanother or the same bank thus

creating more deposits and morereserves to be lent out.

The Money Multiplieris the amount of

money that the banking systemgenerates with each Rupee ofreserves.


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A BANK is an institution which will not beable to pay back all its liabilities if all itsdepositors would want it at one point of time.This could cause the problem ofBANK RUN

if central bank doesnt protect them.

This could also potentially lead to crisis of

confidence in the banking system and itcould lead to collapse of the financialsystem. Recent example in the Indian context wasof ICICI bank. In 1930s the depression was

worsened becoz of this.

Irony of Bank / Financial Institution 1


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Assets Liabilities

First National Bank

ReservesRs10.00

LoansRs90.00

DepositsRs100.00




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Assets Liabilities

First National Bank

ReservesRs10.00

LoansRs90.00

DepositsRs100.00



Assets Liabilities

Second National Bank

ReservesRs9.00

LoansRs81.00

DepositsRs90.00

Total AssetsRs90.00



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Assets Liabilities

First National Bank

ReservesRs10.00

LoansRs90.00

DepositsRs100.00



Assets Liabilities


ReservesRs9.00

LoansRs81.00

DepositsRs90.00

Total AssetsRs90.00



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Assets Liabilities

First National Bank

ReservesRs10.00

LoansRs90.00

DepositsRs100.00



Assets Liabilities


ReservesRs9.00

LoansRs81.00

DepositsRs90.00

Total AssetsRs90.00


Total Money Supply = Rs190.00!


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How much money is eventuallycreated in this economy?

Original deposit = Rs 100.00First National lending = Rs 90.00 [=0.9 x Rs 100.00]Second National lending = Rs 81.00 [=0.9 x Rs 90.00]

Third National lending = Rs 72.90 [=0.9 x Rs 81.00]

Total money supply = Rs. 1,000

f


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What determines the size of themoney multiplier?

The money multiplier is the

reciprocal of the reserve

ratio. With a reserve requirement

(R) of 20% or 1/5 . . .

The multiplier will be 5.

1Rm =

R is like MPS in the case of Keynesian multiplier


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RELATIONSHIP BETWEEN HIGH-POWERED

MONEY AND THE MONEY STOCK (M1 & M3)

Broad Money = M3

Narrow Money = M1


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M = C + D H = Reserve (base) Money

M = Money Supply

H = C + R C = Currency,

R = Reserves with banks

M C + D D = Demand deposits

--- = ---------

H C + R

M C/D + 1

--- = --------------

H C/D + R/D

MONEY

Multiplier

MODEL


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M cdr + 1 cdr = currency-deposit ratio

--- = ------------ r r = reserve-deposit ratio

H cdr + r rcdr + 1

M = ------------ * H

cdr + r r

M = m H Where

cdr + 1

m = ------------

cdr + r r

MONEY

Multiplier

MODEL


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BANK

DEPOSITS

CURRENCY IN

CIRCULATION

Monetary Base

Money Supply


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The functions and measurement ofmoney

The Reserve Bank of India and its

functions Fractional reserve banking - how does

it work?

The money multiplier Tools of Monetary control

Overview

Problems in Controlling the Money


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Problems in Controlling the MoneySupply

2 - problems that the RBI mustwrestle that arise due to

fractional-reserve banking:

1. The RBI does not control the amountof money that households choose tohold as deposits in banks/NBFI.

P bl i C t lli th M S l


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Problems in Controlling the Money Supply

1. The RBI does not control the amount of money

that households choose to hold as deposits inbanks.

2. The RBI does not control the amount

of money that bankers choose/able tolend.

A) The RBI does not control how much

businesses want to borrow from thebanks, e.g. Recession

B) Adverse selection problem Akerlof,

Sti lit

topic 5a money in india pgppm

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