princ ch29 monetary system

29 The Monetary SystemThe Monetary System

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In this chapter, look for the answers to these questions:

What assets are considered “money”? What are the functions of money? The types of money?

What is the Reserve Bank of India (RBI)?

What role do banks play in the monetary system? How do banks “create money”?

How does the RBI control the money supply?

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What Money Is, and Why It ’s Important

Without money, trade would require barter, the exchange of one good or service for another.

Every transaction would require a double coincidence of wants – the unlikely occurrence that two people each have a good the other wants.

Most people would have to spend time searching for others to trade with – a huge waste of resources.

This searching is unnecessary with money, the set of assets that people regularly use to buy g&s from other people.

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The 3 Functions of Money Medium of exchange: an item buyers give to

sellers when they want to purchase g&s

Unit of account: the yardstick people use to post prices and record debts

Store of value: an item people can use to transfer purchasing power from the present to the future

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The 2 Kinds of Money

Commodity money: takes the form of a commodity with intrinsic value

Examples: gold coins, cigarettes

Fiat money: money without intrinsic value, used as money because of govt decree

Example: INR

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The Money Supply The money supply (or money stock):

the quantity of money available in the economy

What assets should be considered part of the money supply? Here are two candidates:

• Currency: the paper bills and coins in the hands of the (non-bank) public

• Demand deposits: balances in bank accounts that depositors can access on demand by writing a check

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MEASURES OF MONEY SUPPLY IN INDIA

The Reserve Bank of India defines the monetary aggregates as: Reserve Money (M0): Currency in circulation + Bankers' deposits with the RBI + 'Other' deposits with the RBI = Net RBI credit to the Government + RBI credit to the commercial sector + RBI's claims on banks + RBI's net foreign assets + Government's currency liabilities to the public - RBI's net non-monetary liabilities.

M1: Currency with the public + Deposit money of the public (Demand deposits with the banking system + 'Other' deposits with the RBI).

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M2: M1 + Savings deposits with Post office savings banks.

M3: M1+ Time deposits with the banking system = Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Government's currency liabilities to the public - Net non-monetary liabilities of the banking sector (Other than Time Deposits).

M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates).

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MANAGEMENT- RBI

CENTRAL BOARD OF DIRECTORS COMPRISING OF 20 MEMBERS:• 1 GOVERNOR & 4 DEPUTY GOVERNORS

APPOINTED BY CENTRAL GOVERNMENT• 4 DIRECTORS NOMINATED BY CENTRAL

GOVERNMENT ONE FROM EACH LOCAL BOARD

• 10 DIRECTORS NOMINATED BY CENTRAL GOVERNMENT

• 1 GOVERNMENT OFFICIAL NOMINATED BY CENTRAL GOVERNMENT

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LOCAL BOARD FOR EACH REGIOANAL AREAS OF THE

COUNTRY THERE IS LOCAL BOARD:• WESTERN – MUMBAI (Head Quarters)• EASTERN – KOLKOTA• NORTHERN- NEW DELHI• SOUTHERN- CHENNAI

Functions: 1)Advising the Central Board

2) Performing other duties delegated by Central Board

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D. Subba Rao: Governor

HR Khan: Deputy Governor

Dr. K C Chakrabarty: Deputy Governor

Subir Gokarn: Deputy Governor

Anand Sinha : Deputy Governor (Now Retired)

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Newly added member (Sep 2011) Dipankar Gupta, Sociologist, former Professor,

JNU, Najeeb Jung, Vice Chancellor, Jamia Millia Islamia, GM Rao, Chairman, GMR Group, Ela Bhatt, founder and General Secretary of SEWA, Indira Rajaraman, Professor Emeritus, National Institute of Public Finance & Policy, Anil Kakodkar, former Chairman, Atomic Energy Commission and Kiran Karnik, former Chairman, NASSCOM.

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Monetary Measures On the basis of the current assessment and in line

with policy stance, the Reserve Bank announces the following policy measures.

Repo Rate It has been decided to reduce the repo rate under

the liquidity adjustment facility (LAF) by 50 basis points from 8.5 per cent to 8.0 per cent with immediate effect.

Reverse Repo Rate The reverse repo rate under the LAF, determined

with a spread of 100 basis points below the repo rate, stands adjusted to 7.0 per cent with immediate effect.

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Marginal Standing Facility

In order to provide greater liquidity cushion, it has been decided to:

• raise the borrowing limit of scheduled commercial banks under the marginal standing facility (MSF) from 1 per cent to 2 per cent of their net demand and time liabilities (NDTL) outstanding at the end of second preceding fortnight with immediate effect.

• Banks can continue to access the MSF even if they have excess statutory liquidity ratio (SLR) holdings, as hitherto.

• The MSF rate, determined with a spread of 100 basis points above the repo rate, stands adjusted to 9.0 per cent with immediate effect.

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Bank Rate

The Bank Rate stands adjusted to 9.0 per cent with immediate effect.

Cash Reserve Ratio

The cash reserve ratio (CRR) of scheduled banks has been retained at 4.75 per cent of their NDTL.

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Expected Outcomes

The policy actions taken are expected to:

• stabilize growth around its current post-crisis trend;

• contain risks of inflation and inflation expectations re-surging; and

• enhance the liquidity cushion available to the system.

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Bank Reserves In a fractional reserve banking system,

banks keep a fraction of deposits as reserves, and use the rest to make loans.

The RBI establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits.

Banks may hold more than this minimum amount if they choose.

The reserve ratio, R= fraction of deposits that banks hold as reserves= total reserves as a percentage of total deposits

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Bank T-account T-account: a simplified accounting statement

that shows a bank’s assets & liabilities.

Example: FIRST NATIONAL BANK

Assets Liabilities

Reserves $ 10

Loans $ 90

Deposits $100

Banks’ liabilities include deposits, assets include loans & reserves.

In this example, notice that R = $10/$100 = 10%.

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Banks and the Money Supply: An Example

Suppose $100 of currency is in circulation.

To determine banks’ impact on money supply, we calculate the money supply in 3 different cases:

1. No banking system

2. 100% reserve banking system: banks hold 100% of deposits as reserves, make no loans

3. Fractional reserve banking system

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CASE 1: no banking system

Public holds the $100 as currency.

Money supply = $100.

21CHAPTER 29 THE MONETARY SYSTEM

Banks and the Money Supply: An ExampleCASE 2: 100% reserve banking system

Public deposits the $100 at First National Bank (FNB).

FIRST NATIONAL BANK

Assets Liabilities

Reserves $100

Loans $ 0

Deposits $100

FNB holds 100% of deposit as reserves:

Money supply = currency + deposits = $0 + $100 = $100

In a 100% reserve banking system, banks do not affect size of money supply.

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Banks and the Money Supply: An ExampleCASE 3: fractional reserve banking system

Money supply = $190 (!!!)depositors have $100 in deposits, borrowers have $90 in currency.

FIRST NATIONAL BANK

Assets Liabilities

Reserves $100

Loans $ 0

Deposits $100

Suppose R = 10%. FNB loans all but 10% of the deposit:

10

90

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How did the money supply suddenly grow?

When banks make loans, they create money.

The borrower gets

• $90 in currency (an asset counted in the money supply)

• $90 in new debt (a liability)

CASE 3: fractional reserve banking system

A fractional reserve banking system creates money, but not wealth.

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If R = 10% for SNB, it will loan all but 10% of the deposit.

SECOND NATIONAL BANK

Assets Liabilities

Reserves $ 90

Loans $ 0

Deposits $ 90

Suppose borrower deposits the $90 at Second National Bank (SNB).

Initially, SNB’s

T-account looks like this:

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81

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If R = 10% for TNB, it will loan all but 10% of the deposit.

THIRD NATIONAL BANK

Assets Liabilities

Reserves $ 81

Loans $ 0

Deposits $ 81

The borrower deposits the $81 at Third National Bank (TNB).

Initially, TNB’s

T-account looks like this:

$ 8.10

$72.90

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The process continues, and money is created with each new loan.

Original deposit =

FNB lending =

SNB lending =

TNB lending = ...

$ 100.00

$ 90.00

$ 81.00

$ 72.90...

Total money supply = $1000.00

In this example, $100 of reserves generate $1000 of money.

In this example, $100 of reserves generate $1000 of money.

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Table Sources:

Individual Bank

Amount Deposited Lent Out Reserves

A 100 80 20

B 80 64 16

C 64 51.20 12.80

D 51.20 40.96 10.24

E 40.96 32.77 8.19

F 32.77 26.21 6.55

G 26.21 20.97 5.24

H 20.97 16.78 4.19

I 16.78 13.42 3.36

J 13.42 10.74 2.68

K 10.74

Total Reserves:

89.26

Total Amount of

Deposits: Total Amount Lent

Out: Total Reserves + Last Amount

Deposited:

457.05 357.05 100

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The Money Mult ipl ier Money multiplier: the amount of money the

banking system generates with each dollar of reserves

The money multiplier equals 1/R.

In our example,

R = 10%

money multiplier = 1/R = 10

$100 of reserves creates $1000 of money

AA CC TT II VV E LE L EE AA RR NN II NN G G 11 : : ExerciseExercise

While cleaning your apartment, you look under the sofa cushion find a $50 bill (and a half-eaten taco). You deposit the bill in your checking account.

The Fed’s reserve requirement is 20% of deposits.

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A. What is the maximum amount that the money supply could increase?

B. What is the minimum amount that the money supply could increase?

AA CC TT II VV E LE L EE AA RR NN II NN G G 11 : : AnswersAnswers

If banks hold no excess reserves, then money multiplier = 1/R = 1/0.2 = 5

The maximum possible increase in deposits is 5 x $50 = $250

But money supply also includes currency, which falls by $50.

Hence, max increase in money supply = $200.

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You deposit $50 in your checking account.

A. What is the maximum amount that the money supply could increase?

AA CC TT II VV E LE L EE AA RR NN II NN G G 11 : : AnswersAnswers

Answer: $0

If your bank makes no loans from your deposit, currency falls by $50, deposits increase by $50, money supply remains unchanged.

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You deposit $50 in your checking account.

A. What is the maximum amount that the money supply could increase? Answer: $200

B. What is the minimum amount that the money supply could increase?

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Origin of RBI

In 1921, 3 Presidency Banks were amalgamated to form the Imperial Bank of India

Existence in 1st April,1935 under RBI Act 1934.

Setting up of such institution was based on recommendation of Hilton Young Commission in the year 1926.

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CONSTITUTION OF RBI CAPITAL – Rs.5 crore

5lakh fully paid up shares of Rs.100 each

Rs. 2.2 lakhs subscribed by the Central Government

Nationalization of RBI in 1st January,1949, entire share capital was acquired by Central Government

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FUNCTIONS OF THE RBI 1) MONOPOLY OF NOTE ISSUE- THROUGH

I) ISSUE DEPARTMENT• II) BANKING DEPARTMENT

• MAINTAINS 18 ISSUE OFFICES; AND NETWORK OF 4301 CURRENCY CHEST AND 4027 SMALL COIN DEPOSITS

• BASIS – I) PROPORTIONAL RESERVE SYSTEM – 40% to consist of coins, bullions, securities BULLIONS

• - MINIMUM RESERVE SYSTEM- SINCE 1957- Rs.515cr.of assets- of which- Rs.400cr. In foreign securities and Rs.115cr. in gold coins & bullions

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FUNCTIONS CONTD. … BANKER TO GOVERNMENT

• ISSUE OF NEW LOANS & TREASURY BILLS

• WAYS & MEANS OF ADVANCES

ADVISER TO GOVERNMENT

CONTROLLER OF CREDIT

EXCHANGE CONTROL AUTHORITY

BANKER’S BANK & LENDER OF LAST RESORT

BANK OF SETTLEMENT & CLEARANCE

PROMOTER OF FINANCIAL SYSTEM

SUPERVISING FUNCTION

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INSTRUMENTS OF CREDIT CONTROL

GENERAL OR QUANTITATIVE• BANK RATE OR THE DISCOUNT RATE POLICY• OPEN MARKET VARIATIONS• VARIABLE RESERVE RATIO (CRR, SLR, NLR)

SELECTIVE CREDIT CONTROL• MINIMUM MARGIN FOR LENDING AGAINST SPECIFIC

SECURITIES• CEILING ON THE AMOUNT OF CREDIT FOR CERTAIN

PURPOSE (Credit Authorization Scheme)• DISCRIMINATORY RATES OF INTEREST ON CERTAIN

TYPES OF ADVANCES

MORAL SUASION

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CRR- CASH RESERVE RATIO-5.5%

The Scheduled commercial banks are required to maintain a minimum cash balance with the Reserve Bank at the close of business on any day.

SLR- STATUTORY LIQUIDITY RATIO-24%

Commercial banks have to maintain liquid assets in cash, gold and unencumbered Government securities amounting to not less than 20% of the total demand and time liabilities.

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MONETARY POLICY AND RECESSION

BANK RATE

MARKET RATE

CREDIT OFFTAKE

MONEY SUPPLY

EXCESS DEMAND

PRICES

RECESSION

(6%- BANK RATE; 5.5%- REPO RATE)

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Monetary Policy

Monetary policy is that part of economic policy in which central bank controls the cost and supply of money and credit.

Monetary policy also called as the Reserve Bank of India’s Credit Policy

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Objective of Monetary Policy

Monetary policy controls:

Supply of money

Availability of money

Set the rate of interest

Maintain price stability

Prevent inflation

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Monetary Policy 2010-11

Highlights of first quarter of the RBI's Monetary Policy for 2010-11

Cash reserve ratio raised by 25 basis points to 6%

Repo rate has been increased by 25 basis points, 5.75%

Reverse repo rate has been increased by 50 basis points, 4.5%

Bank rate retained at 6%

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Economic growth projection seen at 8% for

2010-11

Statutory Liquidity Ratio (SLR) has been left unchanged at 25%

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Highlights of Mid Quarter of the RBI's Monetary Policy for 2010-11

The Repo Rate has been increased by 25 basis point from 5.75% to 6%

The Reverse Repo Rate has been increased by 50 basis point from 4.5% to 5%

However, the CRR, SLR, Bank Rate kept unchanged.

RBI to closely monitor price situation

Lower policy rates can impair inflationary expectations

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Inflation based on WPI is 8.51% in August 2010

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The Fed’s 3 Tools of Monetary Control1. Open-Market Operations (OMOs): the purchase

and sale of U.S. government bonds by the Fed.

To increase money supply, Fed buys govt bonds, paying with new dollars. …which are deposited in banks, increasing reserves…which banks use to make loans, causing the money supply to expand.

To reduce money supply, Fed sells govt bonds, taking dollars out of circulation, and the process works in reverse.

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The Fed’s 3 Tools of Monetary Control1. Open-Market Operations (OMOs): the purchase

and sale of U.S. government bonds by the Fed.

OMOs are easy to conduct, and are the Fed’s monetary policy tool of choice.

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The Fed’s 3 Tools of Monetary Control2. Reserve Requirements (RR).

Affect how much money banks can create by making loans.

To increase money supply, Fed reduces RR.

Banks make more loans from each dollar of reserves, which increases money multiplier and money supply.

To reduce money supply, Fed raises RR, and the process works in reverse.

Fed rarely uses reserve requirements to control money supply: Frequent changes would disrupt banking.

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The Fed’s 3 Tools of Monetary Control3. The Discount Rate:

the interest rate on loans the Fed makes to banks

When banks are running low on reserves, they may borrow reserves from the Fed.

To increase money supply, Fed can lower discount rate, which encourages banks to borrow more reserves from Fed.

Banks can then make more loans, which increases the money supply.

To reduce money supply, Fed can raise discount rate.

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The Fed’s 3 Tools of Monetary Control3. The Discount Rate:

the interest rate on loans the Fed makes to banks

The Fed often uses discount lending to provide extra liquidity when financial institutions are in trouble, such as after the stock market crash of Oct. 1987.

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The Federal Funds Rate On any given day, banks with insufficient reserves

can borrow from banks with excess reserves.

The interest rate on these loans is the federal funds rate.

Many interest rates are highly correlated, so changes in the fed funds rate cause changes in other rates and have a big impact in the economy.

The FOMC uses OMOs to target the fed funds rate.

So fed funds rate policy & monetary policy are connected.

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The Federal Funds Rate

To raise fed funds rate, Fed sells govt bonds (OMO).

This removes reserves from the banking system, reduces the supply of fed funds,

causes rff to rise.

rff

FD1

S2

3.75%

F2

S1

F1

3.50%

The Federal Funds marketfederal

funds rate

quantity of federal funds

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Problems Controll ing the Money Supply

If households hold more of their money as currency, banks have fewer reserves, make fewer loans, & money supply falls.

If banks hold more reserves than required, they make fewer loans, & money supply falls.

Yet, Fed can compensate for household & bank behavior to retain fairly precise control over the money supply.

53CHAPTER 29 THE MONETARY SYSTEM

Bank Runs and the Money Supply A run on banks:

When people suspect their banks are in trouble, they may “run” to the bank to withdraw their funds, holding more currency and less deposits.

Under fractional-reserve banking, banks don’t have enough reserves to pay off ALL depositors, hence banks may have to close.

Also, banks may make fewer loans & hold more reserves to satisfy depositors.

These events increase R, reverse the process of money creation, cause money supply to fall.

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Bank Runs and the Money Supply During 1929-1933, a wave of bank runs and

bank closings caused money supply to fall 28%.

Many economists believe this contributed to the severity of the Great Depression.

Bank runs not a problem today due to federal deposit insurance.

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CHAPTER SUMMARY Money includes currency and various types of bank

deposits.

The Federal Reserve is the central bank of the U.S.,

is responsible for regulating the monetary system.

The Fed controls the money supply mainly through open-market operations. Purchasing govt bonds increases the money supply, selling govt bonds decreases it.

In a fractional reserve banking system, banks create money when they make loans. Bank reserves have a multiplier effect on the money supply.

princ ch29 monetary system

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