THEORY OF MONEY

SUPPLY

Defining Money

Conceptually money can be defined as any commodity that is

generally accepted as a medium of exchange and measure of value.

• Money has three functions: as a medium of exchange, as a

unit of value, as a store of wealth.
• An important property of money is LIQUIDITY. Other assets
are all less liquid
• Money is, therefore, not wealth. Money is not income, which
is a flow of income; Money is a STOCK. Wealth includes
assets other than money.
• Currency is money, but money is NOT JUST currency.
• The narrowest definition of money is:
M1 = C+DD+OD [where C= currency, DD= demand
deposits, OD= other deposits]
M2 = M1+saving deposits with post offices
M3= M1+Time deposits with the commercial banks
M4 = M3+total deposits with post offices
Kinds of Money
• Metallic money
• Paper Money
• Bank deposits
• Plastic money
• Invisible money

CENTRAL BANK

The Reserve Bank of India (RBI) is the central bank of India. It is

responsible for formulating, implementing and monitoring the
monetary policy of India. It plays a key role in the process of
money supply.

Functions of Central Bank

• As a note issuing authority.

• As a banker to the State.
• As a banker to banks.
• Guardian of the money market through credit control.
• As the lender of last resort.
• Maintenance of external value of the domestic currency.
• Ensure price stability.
• Exchange control operations.
• Economic stability.

Supply of Money
The central bank’s liabilities play a key role in the money supply
process.
Liabilities: currency in circulation and reserves. Reserves refer to
the accounts (deposits, currency in bank vaults held by commercial
banks at the central bank).
Central bank assets = government securities, discount loans to
banks, gold and foreign currency assets.

If the central bank increases reserves by 1 rupee, the money supply

increases by a multiplier of this amount.
Central bank increases reserves by:
a) giving loans to banks
b) open market purchases of bonds [reserves at central bank
consists of required reserves, as per required “cash reserve ratio”,
and “excess’ reserves above this.]

OPEN MARKET OPERATIONS

CASH RESERVE RATIO [CRR]

The reserve requirements (or cash reserve ratio) is a central bank

regulation that sets the minimum reserves each bank must hold to
customer deposits and notes. It would normally be in the form of
fiat currency stored in a bank vault (vault cash), or with central
bank. It is an effective instrument of credit control. Under the RBI
(Amendment) Act 1962, the RBI is empowered to determine CRR
for the commercial banks in the range of 3 per cent to 15 per cent
for the aggregate demand and time liabilities. This technique of
credit control was used quite often during the 1970s and 1980s for
contolling inflation.

STATUTORY LIQUIDITY RATIO [SLR]

The amount of liquid aseets, such as cash, precious metals or other
short-term securities, that a financial institution must maintain in
its reserves. The RBI is vested with the power to determine SLR
for commercial banks and to raise it to upto 40 per cent if
necessary.

The objectives of SLR are:

1. To restrict the expansion of bank credit.

2. To augment the investment of the banks in Government
securities.
3. To ensure solvency of banks. A reduction of SLR rates looks
eminent to support the credit growth in India.

The SLR is commonly used to contain inflation and fuel growth,

by increasing or decreasing it respectively. This counter acts by
decreasing or increasing the money supply in the system
respectively.

Difference between SLR & CRR

SLR restricts the bank’s leverage in pumping more money into the
economy. On the other hand, CRR is the portion of deposits that
the banks have to maintain with the Central Bank.

The other difference is that to meet SLR, banks can use cash, gold
or approved securities whereas with CRR it has to be only cash.
CRR is maintained in cash form with RBI, whereas SLR is
maintained in liquid form with banks themselves.

Monetary Base [MB] or High-powered Money

The monetary base (also base money, money base, high-powered

money, reserve money) is a term relating to the money supply, the
amount of money in the economy. It is highly liquid money and
includes currency and vault cash. It consists of coins, paper money,
and commercial banks’ reserves with the central bank.
It is simply reserves plus currency.
MB = C + R (C = currency; R = Reserves)
When the Central bank (RBI) makes loans to banks or buys bonds,
the monetary base increases. The increase may be all as reserves,
or partly as currency, partly as reserves.
Money supply = MB * money multiplier (m)

Deposit creation

To see how the RBI can create deposits, consider an open market
purchase of bonds – by Rs.100, 000 from a bank A.
RBI: assets: + 100 in securities
Liabilities: +100 in reserves because 100 is credited to Bank A’s
RBI account.
So, monetary base is increased by 100.

Monetary base vs reserves

If the bank holds 100 as currency, the MB is increased, but

reserves do not increase.
For the banking system, assets change by +100 as reserves, -100 as
bonds.
Same thing happens if the RBI gives loans to the bank; monetary
base goes up, and may be reserves also if 100 is not held as cash.

The Deposit Multiplier [DM]

Primary deposits leads to the creation of secondary or

derivative deposits, which is a multiple of the primary
deposits.
Let us consider the previous example of Bank A to compute the
Deposit Multiplier.
Assume now that Bank A/s reserves go up by 100 (no increase in
cash holding). Assume a cash reserve ratio of 10%.
Bank A’s reserves have gone up by 100 above required reserves,
and it can lend 100 – to bank B. Out of this 100, bank B has to
keep 10% or 90 as required reserves with the RBI. It can lend 90.

 Bank B Assets Liabilities

 reserves + 10 deposits 100
 Loans (new) 90 (in its RBI
 account)

 Bank C, to whom the loan of 90 is given, has to keep only

10% , 9, as reserves at RBI, can lend out 81:

 Bank C: Assets Liabilities

 Reserves +9 Deposits +90
 New loans +81

 So far the deposits created = 100 + 90 + 81. This process

continues until total new deposits = 1000 (= 100 / 0.1)
 Thus, the deposit multiplier DM:
DM = ∆R / CRR
[where ∆R is the initial change in reserves engineered by the
RBI, and CRR is the required reserve ratio (cash reserve
ratio).]

Deposit Multiplier and the Money Multiplier (m)

But the deposit multiplier is not the actual money multiplier,

because:
If, in this example, Bank B does not deposit 100 in its RBI
account (usually bank transactions are done by movements
between central bank accounts), but holds it cash, the deposit
creation process stops. If this happens anywhere along the way,
the multiplier differs from DM.
Another reason why DM and ‘m’, the Money Multiplier may
differ is that banks may sometimes decide to hold excess
reserves. So, if bank B gets a new deposit of 100, instead of
lending out 90, it may decide to hold excess reserves and lend
out only, say, 70.
Now look at the expression for ‘m’.

The Complete Money Multiplier (‘m’)

The money multiplier ‘m’ is the ratio of the money supply

(stock) to high-powered money.
M = m * H [where H = high powered money or the monetary
base and M = money supply.]

Now,
M = CU + D
[where CU = value of currency in circulation, D = total bank
deposits in the banking system.]
H = CU + Reserves

Let cu = CU/D; re = reserves/D

where ‘re’ is the reserve ratio (CRR).
SO: M = (1+cu)D
H = (cu+re)D

M = (1+cu)
---------- * H
(re + cu)

But, M = m*H
So, Money Multiplier = m = (1 + cu) / (re + cu)

CONCLUSION

Total supply of money depends on the supply of high-power

money and the money multiplier. Therefore, any change in these
will affect money supply.

• If ‘re’ is reduced, ‘m’ rises. Therefore, banks can loan out

more against deposits when CRR is reduced.

• If ‘cu’ is smaller, less currency is held, more money as

deposits in banks – which can be lent out again according to
‘re’. So, smaller ‘cu; increases ‘m’.

• ‘m’ is less than ‘DM’ because there is no multiplier effect for

currency.

• Excess reserves will reduce ‘m’ Then the amount of reserves

held will be more than requires reserves. When market
interest rates are high, banks will keep excess reserves down,
which will reduce actual ‘re’, increasing the money
multiplier.

• The ‘cu’ ratio may be reduced with the availability of ATMs

etc.

• Since M = MB * m, an increase in the monetary base (high

powered money H) will also increase money supply. The
central bank can increase MB by purchasing bonds or by
giving more bank loans at the discount rate.
 • Movements in ‘M” are mostly due to open market bond
purchases.

• The Public: The ‘cu’ ratio is affected by wealth, interest

rates on checking accounts, bank failures and black market
and illegal activities. Of these, only increase in wealth leads
to a reduction in the currency-deposit ratio; increases in the
other factors increase the ‘cu’ ratio. High tax rates causing
evasion may also increase ‘cu’.
• Bank behavior:
EXCESS RESERVES: Bank holding of excess reserves –
which increases the ‘re’ ratio in the expression for ‘m’ – is
affected by market interest rates; higher interest rates will
reduce excess reserves, as banks can profitable lend them out.

• Expected deposit outflows /withdrawals increases excess

reserves.

• Discount loans (loans from central bank at discount rate):

This part of the monetary base is difficult for the central bank
to control; it is easier to control money supply by bond
purchases/sales.
The amount of discount loans banks take are positively
related to market interest rates and negatively related to the
discount rate from the central bank.

The central bank influences the money supply. But the

government’s fiscal policy (spending and budget) also has a role.
The govt budget deficit is:
DEFICIT = Spending – tax revenue
= change in monetary base + sale of bonds;
the deficit is financed by borrowing from the central bank, or
borrowing (sale of bonds).
B. Deficit = ∆MB + ∆Bonds (sale value of bonds sold)
The change in MB, the monetary base occurs because the
government’s (Treasury) bonds are bought by the central bank.

In actual practice, the government may sell bonds to the public,

which are then purchased by the Central Bank. Any way, the
monetary base increases, and has to be multiplied by “m” to get the
increase in money supply.

When foreign currency is bought, commercial bank deposits at

the central bank (reserves) are increased when the central bank
makes payments for the foreign currency, increasing MB.

Ultimate targets for the central bank are inflation, employment and
output levels and growth. To achieve these targets, ‘intermediate
targets” like the rate of interest and the growth of money supply
are needed. To achieve these intermediate targets, the instruments
used are the reserve ratio, open market operations (bond purchases,
sales), the discount rate.

All in all, the theory of supply shows us how the money supply in
the economy is carefully controlled by the government and the
central bank.

THANK YOU
 BIBLIOGRAPHY

www.wikipedia.com

wiki.answers.com
www.scribd.com
www.managementparadise.com

www.universityparadise.com
The 27th Revised Edition of the book “INDIAN ECONOMY- It’s
Development Experience” by S.K. Misra and V.K. Puri published
by the Himalaya Publishing House.