Chapter 4

The supply of money

Learning outcomes• Describe and discuss the different roles of financial intermediaries.

• Describe why maturity transformation is so important in financial markets.

• Define on which side of a bank's balance sheet deposits and loans appear and

• Explain why the balance sheet must indeed balance.

• Explain how the monetary authorities can influence the total money supply by changing the monetary base or by introducing mandatory reserve ratios or other Regulation.

Essential reading• Artis, M.J. and M.K. Lewis Money in Britain:

Monetary policy, innovation and Europe. (New York; London: Philip Allan, 1991).

• Goodhart, C.A.E. Money, Information and Uncertainty. (London: Macmillan, 1989) Chapters 5, 6 and 10.

• McCallum, B. Monetary Economics. (New York; Macmillan; London: Collier Macmillan, 1989).

Financial intermediaries

• Financial intermediaries, such as banks, are hugely important in activities such as the financing of investment projects and in the safekeeping of savings.

• The main service is the collection of funds from those who wish to save and the lending out of funds to those who wish to borrow.

• The reward for providing such services comes from the difference between the rate of interest paid on savings and that charged on loans.

Question

• If there are agents who want to save and others who want to borrow,

• why do those with funds to spare not just lend directly to those who want to borrow?

REASONS FOR EXISTENCE OF FINANCIAL INTERMEDIARIES

• Economies of scale in transactions and information.

Agents with funds to save should hold a large number of different assets (diversified portfolio) but have limited funds available.

If an agent wanted to borrow a large sum of money, to buy a house or factory it is unlikely that they would find a single other agent willing to lend such a large sum.

The financial intermediary may also be able to obtain better information about the creditworthiness of a prospective borrower

• Insurance:

Agents are, in general, risk-averse.

Banks provide insurance services by guaranteeing a rate of return to depositors even if loans made to borrowers turn bad.

Without the bank, the default risk would be faced entirely by the individual/depositor.

• Maturity transformation:

Individual lenders generally want to lend (to the bank) while still having quick access to their money, in order to make transactions or for precautionary motives.

The liabilities of the bank (the deposits of savers) are then liquid and the bank will promise to convert the depositors‘ assets on demand.

• The banks assets, on the other hand, will tend to be illiquid since private borrowers tend to want to hold long maturity liabilities (the loans/assets of the bank).

RBI Measures of Money Supply• The Reserve Bank of India has a long tradition of

compilation and dissemination of monetary statistics, since July 1935.

• In view of the ongoing changes in the Indian economy as well as the developments in monetary sector,

• Working groups were set up periodically to review and refine the monetary aggregates.

Three working groups

• The First Working Group on Money Supply (FWG) (1961),

• The Second Working Group (SWG) (1977) and

• The “Working Group on Money Supply: Analytics and Methodology of Compilation” (WGMS) (Chairman: Dr. Y.V. Reddy) (1998).

CONCEPTS AND DEFINITIONS

• Reserve Money = Currency in circulation + Bankers’ deposits with the RBI + ‘Other’ deposits with the RBI.

• M1 = Currency with the public + Demand deposits with the banking system + ‘Other’ deposits with the RBI.

• M2 = M1 + Savings deposits of 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).

New Monetary Aggregates• NM1 = Currency with the public + Demand

deposits with the banking system + ‘Other’ deposits with the RBI.

• NM2 = NM1 + Short-term time deposits of residents (including and up to the contractual maturity of one year).

• NM3 = NM2 + Long-term time deposits of residents + Call/Term funding from financial institutions.

Liquidity Aggregates• L1 = NM3 + All deposits with the post office

savings banks (excluding National Savings Certificates).

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

• L3 = L2 + Public deposits of nonbanking financial companies.

BALANCE SHEET OF COMMERCIAL BANKS

LIABILITIES ASSETS

1) Share Capital (paid up) 1) Cash Balances

      a) With Central Bank

      b) With other Banks

2) Reserves and surplus 2) Money at call and short notice.

3) Deposits :-  

    a) Time deposits. 3) Bills discounted, including treasury bills.

    b) Demand Deposits  

    c) Saving Deposits  

4) Borrowings 4) Investments

5) Other Liabilities 5) Loans and Advances 

  6) Other Assets.

Liabilities• Capital: The bank has to raise capital before commencing its

business.

• Reserve Fund: Reserve fund is the accumulated undistributed profits of the bank.

• Deposits: The deposits of the public like demand deposits, savings deposits and fixed deposits constitute an important item on the liabilities side of the balance sheet.

• Borrowings from Other Banks: Under this head, the bank shows those loans it has taken from other banks.

• Bills Payable: These include the unpaid bank drafts and telegraphic transfers issued by the bank.

Acceptances and Endorsements: This item appears as a contra item on both the sides of the balance sheet.

• It represents the liability of the bank in respect of bills accepted or endorsed on behalf of its customers and also letters of credit issued and guarantees given on their behalf.

Contingent Liabilities:

• Contingent liabilities comprise of those liabilities which are not known in advance and are unforeseeable.

• Every bank makes some provision for contingent liabilities.

Profit and Loss Account:

• The profit earned by the bank in the course of the year is shown under this head.

• Since the profit is payable to the shareholders it represents a liability on the bank.

Bills for Collection:

• This item also appears on both the sides of the balance sheet.

• It consists of drafts and hundies drawn by sellers of goods on their customers and are sent to the bank for collection, against delivery documents like railway receipt, bill of lading, etc., attached thereto.

AssetsCash:

• Here we can distinguish cash on hand from cash with central bank and other banks cash on hand refers to cash in the vaults of the bank.

• It constitutes the most liquid asset which can be immediately used to meet the obligations of the depositors. Cash on hand is called the first line of defence to the bank.

Money at Call and Short Notice:

• Money at call and short notice includes loans to the brokers in the stock market, dealers in the discount market and to other banks.

• These loans could be quickly converted into cash and without loss, as and when the bank requires.

Bills Discounted:

• The commercial banks invest in short term bills consisting of bills of exchange and treasury bills which are self-liquidating in character.

• These short term bills are highly negotiable and they satisfy the twin objectives of liquidity and profitability.

• If a commercial bank requires additional funds, it can easily rediscount the bills in the bill market and it can also rediscount the bills with the central bank.

• Bills for Collection: As mentioned earlier, this item appears on both sides of the balance sheet.

• Investments: This item includes the total amount of the profit yielding assets of the bank. The bank invests a part of its funds in government and non-government securities.

• Loans and Advances: Loans and advances constitute the most profitable asset to the bank.

• Acceptances and Endorsements: As discussed earlier, this item appears as a contra item on both sides of the balance sheet.

• Fixed Assets: Fixed assets include building, furniture and other property owned by the bank.

INVESTMENT POLICY OF BANKS

• The financial position of a commercial bank is reflected in its balance sheet.

• The balance sheet is a statement of the assets and liabilities of the bank.

• The assets of the bank are distributed in accordance with certain guiding principles.

Liquidity

• In the context of the balance sheet of a bank the term liquidity has two interpretations.

• First, it refers to the ability of the bank to honour the claims of the depositors.

• Second, it connotes the ability of the bank to convert its non-cash assets into cash easily and without loss.

• Liquidity means the capacity of the bank to give cash on demand in exchange for deposits.

• But a commercial bank is a profit – seeking institution. It has to arrange its assets in such a way that it makes maximum profits.

• The bank should also maintain the confidence of public by making cash available on demand.

• It is a well known fact that a bank deals in funds belonging to the public.

• Hence, the bank should always be on its guard in handling these funds.

• The success of a bank depends to a considerable extent upon the degree of confidence it can instill in the minds of its depositors.

• If the depositors lose confidence in the integrity of their bank, the very existence of the bank will be at stake.

Profitability

• The bank has to earn profit to earn income to pay salaries to the staff, interest to the depositors, dividend to the shareholders and to meet the day-to-day expenditure.

• Since cash is the least profitable asset to the bank, there is no point in keeping all the assets in the form of cash on hand.

• The bank has got to earn income. Hence, some of the items on the assets side are profit yielding assets.

• They include money at call and short notice, bills discounted, investments, loans and advances, etc.

• Loans and advances, though the least liquid asset, constitute the most profitable asset to the bank.

• Much of the income of the bank accrues by way of interest charged on loans and advances.

• But, the bank has to be highly discreet while advancing loans.

Liquidity Vs Profitability

• Cash has perfect liquidity but yields no return at all, while other income-yielding assets such as loans are profitable but have no liquidity.

• The bank should strike a balance between liquidity and profitability

RECONCILING TWIN OBJECTIVES

• A good banker is one who follows a wise investment policy and distributes the assets in such a way that both the requirements of liquidity and profitability are satisfied.

• The more liquid the assets, the less profitable it is.

Liquidity vs Profitability Cash :-• Cash balance have perfect liquidity, but no profitability. Cash is held to meet the

withdrawal needs of depositors.

Money At Call :-• Surplus cash of commercial banks is lend to each other. This earns some interest

and is also very liquid.

Investment In Securities :-• Statutorily banks have to invest a part of their assets in government securities.

• These securities have low rate of interest but banks can borrow from RBI against these securities. Thus investment in securities provide returns as well as liquidity to bank.

Loans And Advances :-• Here liquidity is low but profitability is high.

Process of Credit Creation• The credit creating function of the commercial banks is the

process of multiple-expansion of credit.

• The banking system as a whole can create credit which is several times more than the original increase in the deposits of a bank.

• This process is called the multiple-expansion or multiple-creation of credit.

• Similarly, if there is withdrawal from any one bank, it leads to the process of multiple-contraction of credit.

Assumption

(a) The existence of a number of banks, A, B, C etc., each with different sets of depositors.

(b) Every bank has to keep 10% of cash reserves, according to law, and,

(c) A new deposit of Rs. 1,000 has been made with bank A to start with.

Example• Suppose, a person deposits Rs. 1,000 cash in

Bank A.

• As a result, the deposits of bank A increase by Rs. 1,000 and cash also increases by Rs. 1,000. The balance sheet of the bank is as fallows:

• Under the double entry system, the amount of Rs. 1,000 is shown on both sides.

• The deposit of Rs. 1,000 is a liability for the bank and it is also an asset to the bank.

• Bank A has to keep only 10% cash reserve, i.e., Rs. 100 against its new deposit and it has a surplus of Rs. 900 which it can profitably employ in the assets like loans.

• Suppose bank A gives a loan to X, who uses the amount to pay off his creditors.

• After the loan has been made and the amount so withdrawn by X to pay off his creditors, the balance sheet of bank A will be as follows:

• Suppose X purchase goods of the value of Rs. 900 from Y and pay cash.

• Y deposits the amount with Bank B.

• The deposits of Bank B now increase by Rs. 900 and its cash also increases by Rs. 900.

• After keeping a cash reserve of Rs. 90, Bank B is free to lend the balance of Rs. 810 to any one.

• Suppose bank B lends Rs. 810 to Z, who uses the amount to pay off his creditors.

• The balance sheet of bank B will be as follows:

• Suppose Z purchases goods of the value of Rs. 810 from S and pays the amount.

• S deposits the amount of Rs. 810 in bank C.

• Bank C now keeps 10% as reserve (Rs. 81) and lends Rs. 729 to a merchant.

• The balance sheet of bank C will be as follows:

• Thus looking at the banking system as a whole, the position will be as follow:

• It is clear from the above that out of the initial primary deposit, bank advanced Rs. 900 as a loan.

• It formed the primary deposit of bank B, which in turn advanced Rs. 810 as loan.

• This sum again formed, the primary deposit of bank C, which in turn advanced Rs. 729 as loan.

• Thus the initial primary deposit of Rs. 1,000 resulted in bank credit of Rs. 2439 in three banks.

• There will be many banks in the country and the above process of credit expansion will come to an end when no bank has an excess reserve to lend.

• In the above example, there will be 10 fold increase in credit because the cash ratio is 10%.

• The total volume of credit created in the banking system depends on the cash ratio.

• If the cash ratio is 10% there will be 10 fold increase.

• If it is 20%, there will be 5 fold increase.

• When the banking system receives an additional primary deposit, there will be multiple expansion of credit.

• When the banking system loses cash, there will be multiple contraction of credit.

Money Multiplier and Base Money

Lecture Notes

Subject Guide

• Let the total money supply in the economy, M, be made up of deposits, D, and the liabilities of the government, notes and coins, C. Therefore:

• M = D + C (4.1)

• let high-powered money, H, be made up of the notes and coins in the general public, C, and the remainder of the government's liabilities held by banks in the form of reserves, R:

• H = C + R (4.2)

• Dividing (4.1) and (4.2) by D and then dividing one by the other

• The bracketed term is the money multiplier:

• The factor which, when multiplied by the base money, gives the total money supply in the economy.

A simple model of the banking sector

• Assume a banking industry whose market is described by:

• D is the (supply of) bank deposits.

• the interest paid on deposits and

• i the `market' interest rate.

• The supply of deposits is a positive function of the interest rate paid on deposits and a negative function of the market interest rate the interest rate one could earn elsewhere.

• Where L is the (demand for) bank loans

• The demand for loans is a negative function of the interest rate charged on loans.

• If the interest rate you had to pay on a loan was high relative to the market rate, you would borrow, not from the bank, but from elsewhere.

• d0 captures an arbitrary banking relationship constant.

• It represents the minimum an individual would deposit to the bank and the minimum a firm receives from the bank to hold a bank relationship.

Competitive equilibrium

• The profits made by the bank will equal the quantity of loans, L, multiplied by the interest earned on those loans, iL (which is the bank's revenues) minus the costs faced by the bank.

• Costs will equal the interest paid to depositors in order to encourage them to hand over their funds to the bank.

• Costs then equal the quantity of deposits, D, times the interest rate paid on deposits, iD.

• Denoting bank profits by and noting that in a competitive equilibrium, profits equal zero:

• No reserves are kept by the banks

• Bank's balance sheet to balance, loans (assets) must equal deposits (liabilities).

• L = D. Substituting into (4.6) and using (4.7) implies that in equilibrium:

• Substituting into (4.5) and equating L with D gives:

• Solving for the interest rate on deposits, which equals the interest rate charged on loans from (4.8), gives

• This implies total deposits, D, which equals total loans, L, equals d0 from either (4.4) or (4.5).

Equilibrium

Government regulation of the deposit rate

• One way that the government could reduce or control the money supply is by setting a limit on the interest rate paid on deposits.

• If the maximum interest rate banks can pay on deposits is less than i in the above example, then the amount of funds savers are willing to deposit with the bank will fall, resulting in a lower money supply.

Diagram

If government sets the interest rate on deposits equal to zero. From (4.4), the quantity of deposits is fixed at D = d0 - d1i.

Diagram

The level of deposits, and hence of the money supply, has fallen from d0 to d0 - d1ibecause of the government regulation.

Diagram

Since deposits must equal loans in order for the bank's balance sheet to balance

The lower level of deposits means a lower level of loans, which is associated with a higher interest rate charged, iL > i.

Diagram

Since there is a difference between the interest rate charged on loans and that paid on deposits (which has been set at zero),

The government regulation has allowed the banks to make positive profits.

Reserves

• banks will try to keep a fraction of their assets in liquid form in order to meet the day-to-day needs of depositors who withdraw their funds.

• Assume that the government introduces a mandatory reserve ratio, r*.

• The bank's assets now comprise loans, as before, but now include these reserves.

• Its liabilities are just the deposits of its customers.

Assets = Liabilities

Substituting (4.11) into the zero profit condition, (4.6) and (4.7),

As D cancels out.

• The interest rate charged on loans is now higher than the interest rate paid on deposits.

• This is in order to compensate the banks for holding reserves, on which it earns no interest.

• Total loans are now less than total deposits so each dollar lent out must earn a higher return than that paid on each dollar deposited with the bank.

• iL then needs to be greater than iD.

• Substitute out L and D from (4.4) and (4.5) into (4.11).

• Then substituting out iL from (4.12), show that the rate of interest paid on deposits is equal to:

• Substitute this out into the supply of deposits equation, (4.4), and show that total deposits are given by:

• The equation relate the deposit rate and total deposits (money supply) to the market interest rate and to the reserve ratio.

• By changing the mandatory reserve ratio, the government can change the total money supply through the activities of the banking sector.

• However, the way in which D varies with r is uncertain and depends on the parameters of the model.

• With no reserve requirements we equate L to D in order for the bank's balance sheet to balance.

• In this situation we equate L to (1 – r*)D from (4.11).

• Therefore the new intersection results in a lower value of L but a higher interest rate charged, iL.

• Total revenues for the bank, L * iL, could then increase or decrease depending on the elasticity of the demand for loans function.

• If the demand for loans is elastic then, if L falls, revenue will fall.

• Banks will be forced to cut the interest paid on deposits, so iD falls, resulting in fewer deposits and hence causing the money supply to fall.

• If the demand for loans is inelastic, a fall in L, caused by the reserve ratio, will increase revenues.

• The banks will increase iD and so total deposits will increase.

Monetary base control

• The government can control the money supply by directly controlling the rate of interest paid on deposits and it can also affect it through imposing a mandatory reserve ratio.

• However, by forcing the banks to hold a certain level of reserves, not just a reserve ratio, it can directly control the monetary base.

• Note that high-powered money equals reserves plus cash held by the general public and the government directly controls the amount of cash in the economy since it is the monopoly supplier.

• The government fixes the amount of bank reserves, R, at R*.

• This explicitly determines the amount of deposits in the economy since R* = r*D.

• Inverting (4.14) will give an expression for the market interest rate in terms of r* and R*.

• where

• The level of total deposits, and hence the supply of money, is determined by the mandatory requirement that the banks hold a fixed level of reserves, R* and have a fixed reserve ratio, r.

• Changing R will directly affect the money supply, shifting the vertical D = R*/r* schedule left or right.

• It will necessitate a change in the market interest rate in order to achieve equilibrium in the banking sector.