monetary policy2

Medium of exchange Unit of account Measure of value Standard of deferred payments

The classic definition of money is thus “money is what money does”

M1= currency + demand deposits + other deposits

M2 = M1 + post office savings deposits M3 = M1 + term deposits M4 = M3+Post office savings deposits

M 1 = currency in circulation + demand deposits + other deposits

M2 = m1 + cds + term deposits less than 1 yr

M3 = m2 + term deposits exceeding one year + call borrowings from the ndfcs by the banking system

M0 = currency + bankers deposits + other deposits

Issue of currency notes Custodian of foreign exchange reserves Banker to the Government Banker to other banks a) custodian of cash reserves b) lender of last resort c) clearing agent Credit control Promotional role

Objectives: a) stabilisation of price level b) stabilisation of money market c) promoting economic growth Instruments: a) qualitative- controlling the direction of

credit b) quantitative – controlling the volume of

credit

Bank rate: rate at which central banks lend to the commercial banks

Variable Reserve Ratios 1. cash reserve ratio (crr) 2. statutory liquidity ratios (slr) 3. repo and reverse repo rates Open Market operations- buying and selling

Government bonds.

CRR 6 %

SLR 24%

BANK RATE 6%

REPO RATE 8.5%

REVERSE REPO RATE

7.5%

Margin requirements Regulation of consumer credit Credit rationing Moral Suasion Direct action

Step 1: open market operations (sell securities)

leads to reduction in bank reserves Step 2: reduction in money supply Step 3:this causes interest rates to rise (tight money situation) Step4:investment falls ( agg. Demand

falls) Step 5: reduction in income, output,

employment and prices.

liabilities assets

1. Share capital 1. Cash in hand, cash with central bank, cash with other banks

2. Reserve funds 2.Money at call

3. Deposits – time, demand savings

3.Bills discounted including treasury bills

4.borrowings 4.Investments

5.Other items 5.Advances

6.others

An open market purchase of securities by RBI will result in an increase in reserves spread out among all the banks.

If the RBI purchases Rs 1000 worth G- secs from a dealer , and pays in cheques.

The dealer will deposit that in the commercial bank A whose deposits increase by 1000

If the reserve requirements are 20%, the Bank A can lend out Rs 800.

Every loan creates a deposit . Hence in the balance sheet the loans and deposits will increase by 800.

The borrower of 800 will deposit it in his own bank B whose deposits will increase by 800.

Bank B will keep 20%as reserves and lend out 640, thereby creating a new deposit.

The borrower of Rs 640 will deposit in his Bank C.

Total deposit creation will be : 1000+800+640+512………….. =1000(1+.8+.82+……..) = 1000(1/1-.8) =5000

Deposit multiplier = 5 = 1/r r= reserve deposit ratio

Limitations to deposit creation:

1. Public varies its currency holdings2. Banks choose to hold excess reserves3. Commercial banks have time as well as

demand deposits

RESERVES LOANS DEPOSITS

Bank A 200 800 1000

Bank B 160 640 800

Bank C 128 512 640

Bank D 102 410 512

Bank E 82 328 410

If there is a currency withdrawal from Rs 1000. ( CURRENCY DEPOSIT RATIO IS 0.1)

Then the customer will withdraw Rs 91 in cash and keep Rs 909in deposits.

The banks have to keep 20% as crr. So it will lend Rs 727 .

C(n+I )+D(n+1) = .8D(n). C(n+1)=.1D(n+1) 1.1D(n+1) = .8D(n) D(n+1)= .727D(n) Total deposits = 909+661+481+… 909[1+.727+(.727)2 +(.727)3 +….] =3330 Total Currency = 0.1(3330) =333

Liabilities: Monetary liabilities are: Notes in circulation Deposits of financial institutions Deposits of foreign central banks Accounts of international agencies - IMF Deposits of banks (Reserves)

Non monetary liabilities are: Capital account (net worth)• Paid up capital + contingency reserves Government deposits IMF Account no. 1 Misc. – CD, PPF , BILLS

HIGH POWERED MONEY = MONETARY LIABILITIES OF RBI + GOVT MONEY

FINANCIAL ASSETS:A. RBI credit to commercial sector Shares/ bonds of financial institutions Debentures of co-operative sector/banks Loans to financial institutions Internal bills purchased and discounted B. RBI Credit to Government C. RBI’s gross claims on banks Refinance of RBI to banks Fixed investment in bank shares / bonds

D. Net foreign assets Gold coins and bullion Foreign securities Balances held abroad

OTHER ASSETS : Physical assets Others

Monetary liabilities + nonmonetary liabilities = financial assets + other assets

H = Currency + Reserves◦ Currency is held by public and by banks◦ Reserves = vault cash + banks deposits with RBI = Statutory reserves +excess reserves(FA)+(OA) = ML+NMLFA +OA –NML =MLLet NET NML =NML –OAThus FA- NNML=ML

Changes in RBI credit to Government Changes in RBI credit to commercial bank Changes in RBI credit to commercial sector Changes in foreign exchange reserves

Money Supply= currency+deposits High powered money(H)= Currency +

reserves. M = C+D M/D = C/D+1 =c+1 H/D = C/D +R/D = c+r

c=currency deposit ratio r =reserve deposit ratio M = (1+c)/(c+r)H Thus money supply is a multiple of high

powered money. c depends on the cost and convenience

of holding cash r depends on regulations as well as

interest rate. Reserves include excess cash (vault cash)

RBI’s ability to control the stock of money depends on the control over H and the stability and predictability of the money multiplier.

Since c cannot be changed easily, any change in the money multiplier is through r

Volumes of financial flows can be used to define various ratios of financial development

Finance ratios= total financial claims/national income. Shows the relation between financial development and economic development.

Financial interrelations ratio = financial claims/ net physical capital formation.

it shows the relation between financial assets and physical assets.

New issue ratio: primary issues/ net physical capital formation. It shows the degree of financial dis-intermediation.

(primary issues are issued by deficit spenders directly to the surplus spenders)

Intermediation ratio: secondary issues/ primary issues.. It is a measure of financial intermediation.