banking&ms 13

8/3/2019 Banking&Ms 13

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Supply of Money & Banking


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Money Supply

Described as the multiple of the monetary

base, called money supply multiplier

Monetary base = Bank Reserves + CurrencyThat is, MB = R + CU

Money Supply = Deposits + Currency

That is, M = D + CU

Money multiplier is the ratio of the stock of money

to the stock of monetary base


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Deriving Money Multiplier

Step I: Divide the definition of the monetary base by deposits

MB / D = (R/D) + (CU/D) = rd + cu

Step II: Divide the definition of the money supply by deposits

M/D = (D/D) + (CU/D) = 1+ cu

Step III: Take the ratio of step II to step I and substitute thedefinition of cu and rd

M = [(1+cr)/(rd+cu)] MB

Step IV: This leads to m, the definiton of money supplymultiplier

m= [(1+cr)/(rd+cu)]


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Implications

Money multiplier is larger the smaller the

reserve ratio

Money multiplier is larger the smaller

currency deposit ratio


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How has it been effected?

Currency deposit ratio depends to a largerextent upon the cost, convenience of obtainicash, seasons, and so on

Reserve ratio depends upon the Central Banksrequirements

Thus, Central Bank influences monetary basedthrough monetary policies


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Instruments to control money supply

Open market operations

Reserve requirements (CRR: 5.5% & SLR: 24%)

Bank rate (6%) (but now repo rate: 8.5%;reverse repo: 7.5%)

Intervention in forex market

Intervention in credit market fixing quantumof credit


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What is meant by money supply in the

economy?

From July 1935, the concept of money supply

has been compiled by the RBI

It is the sum of currency with the public & thedemand deposits with the banking system

This is referred to as narrow money and

denoted by M1


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economy? .

There is also a concept of broad money-introduced in 1964-65. This is also referred toas Aggregate Monetary Resources

It is the sum of M1 & the time deposits withthe commercial banks

From 1970, several concepts related to money

aggregates which came into effect are-


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economy?

M1currency with public + demand deposits with

the banking system + other deposits with the RBI

Narrow Money

M2 M1+Post office savings bank deposits

M3 M1+Time deposits with the banking system

Broad Money

M4 M3+Total Post office deposits (excludingnational savings certificate)


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Explanations

M1 excludes time deposits

Argument is time deposits are income earning asset& hence illiquid

M3 includes time deposit Argument is time deposits are income earning assets

& people have acquired them by converting cash intotime deposits for earning future interest income &

hence some amount of liquidity is imparted to it


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Explanations

M2 & M4 measures of money supply include

post office savings & other deposits with post

offices. Hence they are a part of liquid assets

& must be a part of aggregate monetary

resources

But owing to certain problems not treated to

be so.


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Balance Sheet of RBI

A. Monetary Liabilities (ML)

A1. Notes in circulation

A2. Other Deposits:

a. Deposits of quasi-

govtb. Balance in the accounts of

foreign central banks &

governments

c. Accounts of

international agencies

A3. Deposits of Banks (Reserves)

Financial Assets (FA)

A. Credit to government

A1. RBI credit to the centre

a. loans & advances

from RBI to centre

b. RBI holdings of

treasury bills, dated

securities, rupee &

small coins

A2. RBI credit to the Stategovernment: loans &

advances to state govts


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Balance Sheet of RBI contd

B. Non-monetary Liabilities (NML)

B1. Capital account (NetWorth)

a.Paid-up capital

b.Statutory Reserve

c.Contingency Reserve,etc

B2. Government deposits

B3. IMF a/c # 1 (since 1948)

B4. Miscellaneous NMLs

e.g/ RBI EmployeesPension Fund, Providentfunds ets

B. Credit to the commercial sector

B1.Shares/Bonds of financialinstitutions

B2. Ordinary debentures of

the cooperative sectorB3. Debentures of co-

operative land mortgagebanks

B4. Loans to financialinstitutions

B5. Internal bills purchased &discounted


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Balance Sheet of RBI contd

-

C. RBIs gross claims on banks

C1. Refinance of RBI to thebanks

C2. Fixed investment in commercialbank shares/bonds & debentures

D. Net Foreign Assets

D1. Gold coin & BullionD2. Eligible foreign securities

D3. Balances held abroad nettedfor balances in IMF A/c # 1minus Indias quota s subscription

in rupees

Other Assets (OA)

A.Physical Assets

B. Others


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Vault Cash

The RBI issues currency (notes of two &above)

The Central Government also issues money in

form of one-rupee notes, coins & small coins

The RBI currency together with thegovernment money with the commercial

banks is treated as Vault Cash


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High Powered Money (H)

The RBI money together with the Government moneyconstitutes the monetary base which is known as HighPowered Money.

High Powered Money = Money liabilities of RBI+ Government money

= Currency with public (C)

+ Reserves (R)

+ Other deposits with RBI

= C+R (neglecting the other deposits withRBI)

Where Reserves (R) vault cash + banks deposits withthe RBI

= Statutory reserves + Excess reserves

Note: GM is negligible & bulk ofH is made up of money

liabilities of RBI


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High Powered Money (H) looked at

alternatively

RBI Assets = RBI Liabilities

(FA)RBI + (OA)RBI = (ML)RBI + (NML)RBI(1)

(FA)RBI

+ (OA)RBI

- (NML)RBI

=(ML)RBI

... (2)Let Net Non-monetary Liabilities (NNML) of RBI be defined as

(NNML) RBI = (NML)RBI (OA)RBI ..(3)

Using (3) in (1), (FA)RBI - (NNML) RBI = (ML)RBI

Now, H = (ML)RBI + GMH = (ML)RBI + GM

H (ML)RBI = (FA)RBI - (NNML) RBI (4)


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Money multiplier for M3

In its simplest form Ms = m.H(5)

Where m is the money multiplier & Ms is the broad money (M3)

Now, M3 = C + DD + TD

m = Ms/H = (C + DD + TD)/(C+R)

= (C + DD + TD)/[C+(DD+TD)r]

Where r = Reserve ratio

= R/(DD+TD)

m = {1+C/DD+TD/DD}/{C/DD+r(1+TD/DD)}

= (1+c+t)/[c+r(1+t)] where c= C/DD & t = TD/DD


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Money multiplier for M1

M1 = C +DD & R = r. DD

Thus, money multiplier is

m = (C+DD)/(C+R)

m = {(1 + C/DD)}/{C/DD+r.(DD/DD)}

m = (c+1)/(c+r)


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Basic algebraic equations of broad

money

Ms = (1+c+t)/[c+r(1+t)]. H

(considering the influence of TD)

Ms = (c+1)/(c+r) . H

(without the influence of TD)


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What happens to money multiplier if banks hold excess

reserves than required?

Let the excess reserve be E & excess

reserves/DD ratio to be e

m = (1+c)/(r+c+e) Ms = (1+c)/(r+c+e).H


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Question

some extracts from the BS of the Central BankItems Rs. In crore

1. Bank deposits 100

2. Government deposits 50

3. Foreign exchange assets 254. Net worth 1800

5. Other non-monetary liabilities 25

6. Credit to Government 1500

7. Credit to commercial sector 5508. Gross claims on banks 800

9. Other assets 75

Assume government money is negligible


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Question .

From the above balance sheet of the CentralBank, calculate

1. Monetary base

2. The required reserve ratio to arrive at amoney supply of Rs. 4000 crore (givencurrency deposit ratio = 0.3)

3. Impact of an open market sale ofgovernment securities by Rs. 100 crore onthe money supply


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Answer

Show the liabilities and assets separately and find outthe ML = 975

High Powered Money = 1075

Required money supply = 40004000 = m * H

m = (1+cu) / (cu + rd) = (1+.3) / (.3+r)

4000 = [(1+.3) / (.3+r)] * 1075 = 3.72

3.72 (.3+r) = 1.3.3+r = .349

r= .349-.3=.049 or 4.9%


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Answer

If the Central bank sells Govt. sec, it will

reduce H by 100 cr

Keeping all other variables same, money supply will

come down

975 * 3.72 = 3627


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Concept of Sterilization Inflow / outflow of forex creates imbalances ; affects the

assets of the central bank and so the high poweredmoney

Depending upon the inflationary situation, the centralbank needs to follow either contractionary (reducingmoney supply) or expansionary (increasing moneysupply) policies

Resorting of the central bank to these polices to correctfor the imbalances created by changes in forex assets isknown as sterilization


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Question

B/S Items Rs. In crore

Government Money 60

Credit to commercial sector 1500

Notes in circulation 250Credit to Government 850

Statutory and Paid up capital 1200

Government deposits 350

Gross claims on banks 600

Foreign exchange assets 550

Other non- monetary liabilities 75

Physical assets 115


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Question .

Given the currency deposit ratio of 3 % and

reserve deposit ratio of 5 %

a. Calculate the money supply in the economy

b. What will be the new reserve ratio if an

additional inflow of FDI of Rs. 100 Cr has tobe 50 % sterilized?


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Answer

a. 25750 = (1.03/.08) * 2000

(ML = 1940; GM = 60)

b. 27037.5 = (1.03/1.08) * 2100Therefore 50% of change in money supply = 27037.5-25750 =

1287.5 / 2 = 643.75

Therefore 257540 +643.75 = 26393.75

Hence reserve ratio = 26393.75 = (1.03/r+.03) * 2100

12.56 (r + 0.03) = 1.03

r + 0.03 = .082

r= 0.052 or 5.2 %

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