CCCDBEE (2019-20) Handout-07

MONEY MARKET AND MONETARY POLICY

MONEY DEFINED
The economic definition of money is any asset that people are generally willing to accept in exchange for goods and
services or payment of debts. In other words, money can be defined as anything that is generally accepted as a medium of
exchange and measure of value. Form of money has changed over the period from cattle to credit cards. Anything used as
money performs four functions: primary functions (medium of exchange and measure of value); secondary functions
(store of value and standard of deferred payments).
(i) Medium of exchange: Money serves as a medium of exchange when sellers are willing to accept it in exchange
for goods and services. An economy is more efficient when a single good is recognized as a medium of
exchange.
(ii) Unit of account: In a barter system, each good has many prices. A cow may be worth two plows, 20 bushels of
wheat, or six axes. Instead of having to quote the price of a single good in terms of many other goods, each good
has a single price quoted in terms of the medium of exchange. This function of money gives buyers and sellers a
unit of account, a way of measuring value in the economy in terms of money.
(iii) Store of value: Money allows value to be stored easily. If you do not use all your accumulated rupees to buy
goods and services today, you can hold the rest to use in the future. The acceptability of money in future
transactions depends on its not losing value over time. Money is not the only store of value. Any asset
represents a store of value. Why, then, would you bother to hold any money? Answer has to do with liquidity, or
the ease with which a given asset can be converted into the medium of exchange. When money is the medium of
exchange, it is the most liquid asset. People are willing to hold some of their wealth in the form of money, even
though other assets offer a greater return as a store of value.
(iv) Standard of deferred payment: Money can facilitate exchange at a given point in time by providing a medium of
exchange and unit of account. It can facilitate exchange over time by providing a store of value and a standard
of deferred payment. For example, a furniture maker may be willing to sell a chair to a boat builder now in
exchange for money in future.

MONEY SUPPLY
The central bank of a country – the RBI in India – is the main source of money supply (currency) in the country. The
second major source of money supply is the banking system of the country. Money created by the banking system is
known as ‘Credit Money’. The banking system creates credit money through its deposit and lending operations. There
are mainly three types of bank deposits, (i) Current account deposits (also known as demand deposits); demand deposits
are known as ‘bank money’ or ‘credit money’; (ii) Savings bank deposits; and (iii) Fixed (Time) deposits (including
Recurring Deposits)

Various measures of monetary aggregates in India are described below:

(i) M0 (Reserve Money): Currency in circulation + Bankers' deposits with the RBI + Other Deposits with RBI
(ii) M1 (Narrow Money): Currency with public + Demand deposits with the banking system + Other deposits with
RBI
a. Currency with public is arrived at after deducting cash with banks from total currency in circulation as
reported by RBI (The term public means all economic units including households, firms and
institutions. It does not include the producers of money, viz., the RBI, the Government and the
commercial banks)
b. Demand deposits include current account deposits and demand liability portion of savings bank
deposits
c. Other deposits with RBI include deposits from foreign central banks, multilateral institutions, financial
institutions
(iii) M2: M1 + Savings deposits of post office savings banks
(iv) M3 (Broad Money): M1 + Time deposits with the banking systems
(v) M4: M3 + All deposits with post office savings banks

 Creation of Credit Money by commercial banks:

o Money/cash deposited with banks is called as Primary Deposit.
o As demonstrated in the class, on the basis of Primary Deposit, banks create Secondary Deposits or
Derivative Deposits (volume of derivative or secondary deposits constitutes the money supply by the banks)
 Amount of total derivative deposits depends on: (1) Amount of primary deposits; (2) Rate of
Required Reserves; (3) Demand for loans by the society; and (4) Efficiency of banking system.
 Deposit multiplier = [Total deposits, i.e., primary + secondary deposits] / [Primary deposits] = 1/RR
 RR (reserve requirements) in India includes Cash Reserve Ratio and Statutory Liquidity Ratio
 Credit multiplier = [Additional credit creation / Primary deposits] = [1 – RR] / RR
 Money multiplier = [M3 / M0] or [Broad Money / Reserve Money]

DEMAND FOR MONEY

 ‘Demand for money’, ‘holding money’, ‘demand for cash balances’ and ‘liquidity preference’ are used
interchangeably.
Money/cash balance is demanded for following motives: Transaction & precautionary motive, and speculative motive
 Transaction & precautionary demand for money (MT) is direct function of income
o The need for holding money arises because there is a time gap between the receipt of income and
expenditure
o Both households and firms hold some money in excess of their transaction demand to provide for
unforeseen contingencies
o Both transaction and precautionary demand for money are assumed to be interest-inelastic
o MT = kY, where ‘k’ is the fraction of income held as an average money balance for transaction and
precautionary purposes, and ‘Y’ is income level
 Speculative demand for money (MSP) is inverse function of interest rate
o Some money is held as idle cash balance to take advantage of the changes in money market (bond
prices). The market value of the bond is simply the present value of income stream expected from the
bond.
o The market value of bonds and the market rate of interest are inversely related. A rise in the market rate
of interest leads to decrease in the market value of the bond, and vice versa.
o It is rational to hold idle cash balance instead of holding a bond if the interest rate is expected to rise in
future. If the interest rate does increase in future, the bond prices go down. Then the person who holds
the idle cash can buy the bond at a lower price and make a capital gain.
o If the market rate of interest falls to a critical minimum level, everyone starts believing that the interest
rate will only rise and bond prices will decrease in future, then everyone starts selling their bonds and
accumulating cash balances. This is known as liquidity trap. Any increase in money supply will not
lead to increased money in circulation, everyone will hold cash balances.
o MSP = - hi, where ‘h’ is interest sensitivity of holding money/cash balances for speculative purposes
and ‘i’ is interest rate.
 Keynesian demand for money function
o Md = MT + MSP
o Md = kY – hi

MONEY MARKET EQUILIBRIUM

 Supply of money (Ms) = Ḿ
 Demand for money
o Md = MT + MSP
o Md = kY – hi
 Equilibrium in money market: when demand for money = supply of money
Ḿ = Md
Ḿ = kY – hi
hi = kY - Ḿ
k Y − Ḿ
i=
h
MONETARY POLICY
Monetary policy, in general, refers to the action taken by the monetary authorities to control and regulate the demand for
and supply of money with a given purpose. Monetary policy is one of the two most powerful tools (fiscal policy being
the other tool) of economic control and management of the economy. The scope of monetary policy spans the entire area
of economic transactions involving money and the macroeconomic variables that monetary authorities can influence and
alter by using the monetary policy instruments. The scope of monetary policy depends, by and large, on two factors: (i)
the level of monetization of the economy; and (ii) the level of development of financial/capital market. In a fully
monetized economy, all economic transactions are carried out with money as a medium of exchange. In that case,
monetary policy works by changing the supply of and demand for money and the general price level. It is therefore
capable of affecting all economic activities – production, consumption, savings and investment. Moreover, where capital
market is developed, monetary policy affects the level of economic activities through the changes in the capital market. It
works faster and more effectively in an economy with a fully developed financial market. A developed financial market
is characterized by following features: (a) there exists a large number of financially strong commercial banks, financial
institutions, and credit organizations; (b) a major part of financial transactions are routed through the banks and the
capital markets; (c) the working of capital sub-markets is inter-linked and interdependent; and (d) commodity sector is
sensitive to the changes in the capital market.

OBJECTIVES OF MONETARY POLICY:

Monetary policy being an organ of the overall economic policy, its objectives could not be different from or be in
conflict with the overall objectives of other economic policies of the country. The three major objectives of India's
overall economic policy have been (i) economic growth, (ii) social justice, i.e., an equitable distribution of income, and
(iii) price stability. Of these objectives, growth and price stability have been in general the objectives of India's monetary
policy. However, price stability has been the key objective of Indian monetary policy.

INSTRUMENTS OF MONETARY POLICY

 Cash Reserve Ratio (CRR): Cash Reserve Ratio is a certain percentage of Net Demand and Time Liabilities (i.e.,
deposits) which banks are required to keep with RBI in the form of reserves or balances. Higher the CRR, the lower
will be the liquidity in the system and vice versa.
 Statutory Liquidity Ratio (SLR): Every financial institution has to maintain a certain quantity of liquid assets with
themselves at any point of time as a percentage of their Net Demand and Time Liabilities. These assets have to be
kept in forms such as government securities, gold or cash. Higher the SLR, the lower will be the liquidity in the
system and vice versa. 
 Repo Rate and Reverse Repo Rate: Repo rate is the rate at which RBI lends to commercial banks against
government securities. It consists of overnight as well as term repo for 7/14/28 days. Reduction in repo rate helps the
commercial banks to get money from RBI at a cheaper rate and increase in repo rate discourages the commercial
banks to get money as it becomes expensive. The increase in the repo rate will increase the cost of borrowing and
lending of the commercial banks. Thus increased repo rate may tend to increase market interest rates and vice versa.
Reverse repo rate is the rate at which commercial banks can park their excess funds with RBI.
 Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow additional
amount of overnight money from the Reserve Bank by dipping into their SLR portfolio up to a limit (currently two
per cent of their net demand and time liabilities) at a penal rate of interest (currently 25 basis points above the repo
rate). This provides a safety valve against unanticipated liquidity shocks to the banking system.
 Open Market Operations: Open market operations involve buying and selling of government securities from or to
the banks and public. OMOs influence the reserves of the banks. The RBI sells government securities to squeeze the
flow of credit and buys government securities to increase the flow of credit in the economy.
 Credit Rationing: Under credit rationing, RBI issues directions on lending to the specific sectors. In this case,
commercial bank will be tight in advancing loans to the public. They will allocate loans to limited sectors. For
example - agriculture sector advances, priority sector lending etc.
 Moral Suasion: Moral Suasion is simply persuasion by the RBI to the commercial banks to take particular actions
and measures according to objectives of the policy and trends of the economy. For e.g., RBI may request
commercial banks not to give loans for unproductive purpose which does not add to economic growth but increases
inflation.

TYPES OF MONETARY POLICY

 Expansionary monetary policy: Expansionary monetary policy or loose monetary policy is used to counter a
slowdown or recession. Measures that can be taken include: decrease in CRR, decrease in SLR; decrease in repo
rate and reverse repo rates; and/or decrease in MSF rate. All these measures will lead to reduction in market
interest rates and increase the flow of credit in the economy. This raises investment (or aggregate demand) and
consequently higher GDP growth is achieved.
 Contractionary monetary policy: Contractionary monetary policy or tight monetary policy is used to counter
high inflation. Measures that can be taken include: increase in CRR, increase in SLR; increase in repo rate and
reverse repo rate; and/or increase in MSF rate. All these measures will raise market interest rates and reduce the
flow of credit in the economy, thus decreased investment (or aggregate demand) and consequently lower
demand side inflation.
MONETARY POLICY AND TRANSMISSION MECHANISM
 The policy rate changes made in the monetary policy transmit through the money market to alter the interest
rates in the financial system, which in turn influence aggregate demand - a key determinant of inflation and
growth. When policy rates are increased (or reserve ratios are increased to reduce liquidity), market interest
rates also rise. This rise in market interest rates leads to fall in investment and controls inflation. This process by
which monetary policy changes ultimately affect the aggregate demand is known as transmission mechanism.
Similar transmission mechanism will work in case of decrease in policy rates or reserve ratios also.
 If the commercial banks do not change their interest rates in the intended direction in response to changes in
policy rates by RBI or if the investment does not respond to the changes in the market interest rates, then
monetary policy may not have the intended effect on the economy. This is called failure of monetary
transmission mechanism. Thus, the effectiveness of monetary policy actions depends on working of the
transmission mechanism.
Current Policy Rates and Reserve Ratios
Instrument Current Rate
CRR 4%
SLR 18.75%
Repo rate 5.40%
Reverse Repo rate 5.15%
Marginal standing facility 5.65%