CA Course

Paper No. 8B - Economics for Financeunit 2-MONEY SUPPY

Dr C.Anirvinna

PRODUCTION FRONTIER CURVETHE MONEY MARKET

➢ Definition of money supply and differentcomponents of money supply

➢ Rationale of measuring moneysupply

➢ Different sources of money supply

➢ Illustrate the various measures of moneysupply

➢ Distinguish between money multiplier andcredit multiplier/deposit multiplier, and

➢Different determinants of money supply

LEARNING OUTCOMES

➢Money Supply refers to the total sum of money available to the public in the economy at a point of time usually taken as a year.

➢ The Supply of Money is a stock concept

➢The rationale of measuring money supply

➢The sources of money supply in the economy

DEFINITINO OF MONEY SUPPLY

• Monetary policy deals with money supply in the economy with broad aim of regulating its growth so as control rate of inflation .

• From April 1997 RBI employs 4 components of money supply.• M1 = Currency in circulation + Demand deposits with

banking system +Other deposits of RBI (UTI, NABARD, World Bank, IMF, IDBI & IFCI) M1 is known as Narrow Money

• M2 =M1 + Post office saving deposits

• M3 =M1+ Time deposits with banking system. M3 is known as Broad Money

• M4 = M3 + Total Post office saving deposits ( excluding NSC)

MONEY SUPPLY COMPONETS

The RBI has started publishing a set of four new monetary aggregates following recommendations of the Working Group on Money Supply• NMO (Reserve Money) = Currency in Circulation +

Banker’s deposit with the RBI + other deposits with the RBI

• NM1 = Currency with the public + Demand deposits with the banking system + Other deposits with the RBI

• NM2 = NM1+ Short term deposits of Residents (including and up to contractual maturity of one year )

• NM3 =NM2+ Long Term deposits of residents + call/ Term funding from Financial institutions

Recommendations of Working Group on money1998-New Monetary Aggregates

• The Liquidity Aggregates are:

• L1 =NM3+ All deposits with Post office Savings bank ( excluding NSC)

• L2 = L1 + Term deposits with term lending institutions and refinancing institutions (FIs) +Term borrowing by FIs +Certificate of Deposits issued by FIs

• L3 = L2 + Public deposits of non – banking financial companies

Recommendations of Working Group on money1998-New Monetary Aggregates

• Reserve Money/ Government Money/ High power Money

• The Measure of High Power Money : H = C+R +O

• Where C = currency held by public

• R = Cash balances of commercial banks

• 0= Other liabilities of RBI

• Since O is significant the high power money supply for all practical purposes is measured as

H = C +R

Reserve Money or Base Money or Government Money or High Power Money

• Money Multiplier (m) : It refers to the degree to which money supply expanded as a result of increase in high power money

• Thus m =𝑀

𝐻where M =Money Supply and H =Monetary Base

• The size of money multiplier is determined by • cash reserve ratio set by commercial banks (r), • excess reserves set by banks (e) and• currency deposit ratio of public (c )

• Money Multiplier (m) = 𝑀

𝐻=

𝟏+𝒄

𝒓+𝒆+𝒄• Where r = cash reserve ratio• e= excess reserves ratio set by banks

c = currency deposit ratio

Money Supply M = 1+𝑐

𝑟+𝑒+𝑐×H

Money Multiplier

• The above equation can be interpreted in the following way

1. Money Supply (M) is directly proportional to the monetary base (H).

2.Money Supply (M) inversely related with r, eand k.

Thus money supply in the economy depends upon the behaviour of central bank, commercial banks and general public

Money Multiplier

➢Money Multiplier approach to Supply of Money identifies 3 factors as immediate determinants to supply of money

a.The stock of high powered money (H)

b.The Ratio of reserves to deposits ( Reserves/Deposits ER/D) and

c.The Ratio of Currency to deposits c =(C/D)

Money Multiplier approach to Supply of Money

➢The supply of money varies directly with monetary base or high power money and varies inversely with the currency and reserve ratios

The Behaviour of the Central Bank

➢ Commercial banks do keep a certain percentage of deposits as cash reserves stipulated by central bank.

➢ Impact of increase/decrease in such reserves ➢ In practice banks keep more than required

percentage as reserves to meet any unexpected contingencies.

➢Any such excess reserves do not lead to creation of money

➢ Excess reserves involves an opportunity cost➢ If deposit outflow is likely to increase, then banks

hold excess reserve and vice versa

The Behaviour of the Commercial banks

➢ The amount of currency held by public relative to deposits will determine the nominal deposits of commercial banks

➢For example public hold more cash on their hand and then lesser the credit expansion in the economy and vice versa

The Behaviour of the Public

➢ To summarize the money multiplier approach, thesize of the money multiplier is determined by therequired reserve ratio (r) at the central bank, theexcess reserve ratio (e ) of commercial banks and thecurrency ratio (c) of the public. The lower theseratios are, the larger the money multiplier is

➢ In other words, the money supply is determined byhigh powered money (H) and the money multiplier(m) and varies inversely with the currency andreserve ratios.

The Behaviour of the Public

➢ It is one of the outstanding features of commercial banks.

➢ The loan given by the bank becomes the deposit for another and thus process keep on going which can be explained with a hypothetical example.

➢ Banks do keep a certain percentage as reserves say 20% out of the deposit received from customer X

➢ So credit multiplier = 1

𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑠𝑒𝑣𝑒 𝑟𝑎𝑡𝑖𝑜

➢ = 1

0.20=5

CREDIT CREATION BY COMMERCIAL BANKS

CREDIT CREATION BY COMMERCIAL BANKS

Liabilities Rs Assets Rs

Deposits 1000 Cash 1000

1000 1000

Balance sheet of bank A

CREDIT CREATION BY COMMERCIAL BANKS

Liabilities Rs Assets Rs

Deposits 1000 reserves 200

Loan to x 800

1000 1000

Balance sheet of bank A

CREDIT CREATION BY COMMERCIAL BANKS

Liabilities Rs Assets Rs

Deposits 800 Cash 800

800 800

Balance sheet of bank B

CREDIT CREATION BY COMMERCIAL BANKS

Liabilities Rs Assets Rs

Deposits 800 reserves 160

securites from Z 640

800 800

Balance sheet of bank B

CREDIT CREATION BY COMMERCIAL BANKS

Liabilities Rs Assets Rs

Deposits 640 reserves 640

640 640

Balance sheet of bank C

• This process will continue till the original excess reserve in the first bank has been parceled out to various banks.

• The total deposits which gets created by over a period of time 5 times of original deposits

• Potential Credit Expansion = initial excess reserve x 1

𝐶𝑎𝑠ℎ 𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑅𝑎𝑡𝑖𝑜• = 800x1/20 =Rs 4000• The total deposits created are Rs 5000 in the banking

system. Which includes Rs1000 original and the remaining Rs 4000 deposits made by the banking system

CREDIT CREATION BY COMMERCIAL BANKS

➢ If the central bank of a country wants to stimulate economic activity it does so by infusing liquidity into the system through OMO

➢ Assuming that banks donot hold excess reserves and people do not hold more currency than before, and also that there is demand for loans from businesses, the credit creation process by the banking system in thecountry will create money to the tune of

➢ ∆Money Supply =𝟏

𝐑X ∆ Reserves

➢ The effect of open market sale is very similar to that open market purchase

Monetary Policy and Money Supply

➢ Ways and Means Advances (WMA)/overdraft (OD) facility.

➢ . When Govt incurs expenditure resulting in it debiting thegovernment balances with the Reserve Bank and crediting the receiver (for e.g., bank account of a worker) account with the commercial bank.

➢ The extra reserves thus created can potentially lead to an increase in money supply through the money multiplierprocess.

EFFECT OF GOVERNMENT EXPENDITURE ONMONEY SUPPLY

1 . W h a t d o y o u m e a n b y r e s e r v e m o n e y ?

2 . H o w d o y o u d e t e r m i n e t h e s i z e o f m o n e y m u l t i p l i e r ?

3 . C o m m e r c i a l b a n k s a r e m a n u f a c t u r e r o f c r e d i t i n t h e e c o n o m y – S u b s t a n t i a t e

4 . H o w d o e s w a y s a n d m e a n s a d v a n c e s a f f e c t t h e m o n e y s u p p l y i n t h e e c o n o m y ?

5 . E x p l a i n m o n e y m u l t i p l i e r a p p r o a c h t o m o n e y s u p p l y

PRACTICE QUESTIONS

1. M is inverse ly re lated to H and direct lyre lated to r

2 . Supply of money is a stock concept

3. Money supply might impact inf lat ion inthe economy

4. M2 inc ludes post off ice sav ing depos i ts

5. M is inverse ly re lated to c

TRUE OR FALSE

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