29 The Monetary System

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?

2
 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.

3
 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

4
 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
5
 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

6
 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).
7
 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).

8
 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

9
 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

10
 D. Subba Rao: Governor
 HR Khan: Deputy Governor
 Dr. K C Chakrabarty: Deputy Governor
 Subir Gokarn: Deputy Governor
 Anand Sinha : Deputy Governor (Now
Retired)

11
 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.

12
 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.
13
 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. 14
 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.

15
 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.

16
 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
17
 Bank T-account
 T-account: a simplified accounting statement
that shows a bank’s assets & liabilities.
 Example: FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10 Deposits $100
Loans $ 90

 Banks’ liabilities include deposits,

assets include loans & reserves.
 In this example, notice that R = $10/$100 = 10%.
18
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

19
Banks and the Money Supply: An Example
CASE 1: no banking system
Public holds the $100 as currency.
Money supply = $100.

20
Banks and the Money Supply: An Example
CASE 2: 100% reserve banking system
Public deposits the $100 at First National Bank (FNB).
FNB holds
100% of FIRST NATIONAL BANK
deposit Assets Liabilities
as reserves: Reserves $100 Deposits $100
Loans $ 0
Money supply
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system,
banks do not affect size of money supply.
CHAPTER 29 THE MONETARY SYSTEM 21
Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
Suppose R = 10%. FNB loans all but 10%
of the deposit:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $100
10 Deposits $100
Loans $ 90
0

Money supply = $190 (!!!)

depositors have $100 in deposits,
borrowers have $90 in currency.
22
Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
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)
A fractional reserve banking system
creates money, but not wealth.

23
Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
Suppose borrower deposits the $90 at Second
National Bank (SNB).

Initially, SNB’s SECOND NATIONAL BANK

Assets Liabilities
T-account Reserves $ 909 Deposits $ 90
looks like this: Loans $ 81
0

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

deposit.

24
Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
The borrower deposits the $81 at Third National
Bank (TNB).

Initially, TNB’s THIRD NATIONAL BANK

Assets Liabilities
T-account Reserves $ $8.10
81 Deposits $ 81
looks like this: Loans $ 0
$72.90

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

deposit.

25
Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
The process continues, and money is created with
each new loan.

Original deposit = $ 100.00 In

In this
this
FNB lending = $ 90.00 example,
example,
SNB lending = $ 81.00 $100
$100 ofof
TNB. lending = $ 72.90 reserves
reserves
.. .. generate
. generate
$1000
$1000 of of
Total money supply = $1000.00 money.
money.

26
 Table Sources:
Individual
Amount Deposited Lent Out Reserves
Bank
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 Total Amount Lent Total Reserves + Last Amount
Deposits: Out: Deposited:
457.05 357.05 100

27
 The Money Multiplier
 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

28
ACTIVE LEARNING 1:
Exercise
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.
A. What is the maximum amount that the
money supply could increase?
B. What is the minimum amount that the
money supply could increase?

29
ACTIVE LEARNING 1:
Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
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.
30
ACTIVE LEARNING 1:
Answers
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?
Answer: $0
If your bank makes no loans from your deposit,
currency falls by $50, deposits increase by $50,
money supply remains unchanged.
31
 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.

32
 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

33
 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

34
 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 35
 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
36
 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.
37
 MONETARY POLICY AND
RECESSION
BANK RATE
MARKET RATE
CREDIT OFFTAKE
MONEY SUPPLY
EXCESS DEMAND
PRICES
RECESSION
(6%- BANK RATE; 5.5%- REPO RATE)
38
 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

39
Objective of Monetary Policy

Monetary policy controls:

 Supply of money
 Availability of money
 Set the rate of interest
 Maintain price stability
 Prevent inflation

40
 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%
41
 Economic growth projection seen at 8% for
2010-11
 Statutory Liquidity Ratio (SLR) has been left
unchanged at 25%

42
 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

43
 Inflation based on WPI is 8.51% in August 2010

44
The Fed’s 3 Tools of Monetary Control
1. 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.

45
The Fed’s 3 Tools of Monetary Control
1. 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.

46
The Fed’s 3 Tools of Monetary Control
2. 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.
47
The Fed’s 3 Tools of Monetary Control
3. 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.

48
The Fed’s 3 Tools of Monetary Control
3. 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.

49
 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.
50
 The Federal Funds Rate
To raise fed funds The Federal
rff Funds market
rate, Fed sells federal
funds rate
govt bonds (OMO). S2 S1

This removes 3.75%

reserves from the
banking system, 3.50%
reduces the supply
of fed funds,
causes rff to rise. D1
F
F2 F1
quantity of
federal funds
51
Problems Controlling 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.

52
 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.
CHAPTER 29 THE MONETARY SYSTEM 53
 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.

54
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. 55