Session 09-10

MONEY DEMAND AND MONEY SUPPY

PROCESS

(MONETARY POLICY)

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 What is money?

?
Types of money

• Fiat money
• Legal tender money
• ‘Near money’

2
 Functions of money
• Medium of exchange
• Money is used to pay for goods and services
• Eliminates the need for a “double coincidence of wants”

• Unit of account
• The unit in which prices are quoted

• Store of value
• An asset that maintains value

• Standard of deferred payment

• Money units are used in long term transactions (example: loans)

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 The Demand for Money Theory
Demand for money refers to the stock of assets held as cash, checking (SB/current)
accounts, and closely related assets, specifically not generic wealth or income.

The theories correspond to Keynes’s famous three motives for holding money:

Sources of money demand

The transaction motive, which is the demand for money arising from the use of
money in making regular payments. Mt= k(Y)

The precautionary motive, which is the demand for money to meet unforeseen
contingencies.Mp = k(Y)

Speculative motive, which arises from uncertainties about the money value of
other assets that an individual can hold. Msp= h(r)
Md = L(Y,r)
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 The Demand for Money Theory

Real balance equation

Md
 kY  hr
P
k, h  0

Transaction and precautionary motives → mainly discussing M1

Speculative motive → M3, as well as non-money assets

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 The Demand for Money: Theory

• The demand for money is the demand for real money balances.

→ people hold money for its purchasing power.

– Two implications:
1. Real money demand is unchanged when the price level
increases, and all real variables, such as the interest rate,
real income, and real wealth, remain unchanged.

2. Equivalently, nominal money demand increases in

proportion to the increase in the price level, given the
real variables just specified.
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 Empirical Estimates
• Four essential properties of money demand:

– Demand for money balances responds negatively to the rate of interest.

– Demand for money increases with the level of real income.

– Short-run responsiveness of money demand to changes in interest rates

and income is considerably less than the long-run response. (the long-
run responses are estimated to be about 5 times the size of the short-run
responses)

– Demand for nominal money balance is proportional to the price level.

There is no money illusion; in other words, the demand for money is a
demand for real balances.

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 The Quantity Theory
• The quantity theory of money provides simple way to think about the
relation between money, prices, and output:

M V  P Y
– The equation is the famous quantity equation (equation of exchange), linking
the price level and the level of output to the money stock.

– The quantity equation became the classical quantity theory of money with it
was argued that both V and Y were fixed.

 If both V and Y are fixed, it follows that the price level is proportional to the money
stock

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 The Quantity Theory
• The classical quantity theory = theory of inflation

– The price level is proportional to the money stock:

V M
P
Y
– If V is constant, changes in the money supply translate into
proportional changes in nominal GDP

– With the classical case (vertical) supply function, Y is fixed, and

changes in money translate into changes in the overall price level, P

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 The Income Velocity
• The income velocity of money: the number of times the stock of money is
turned over per year in financing the annual flow of income.

– Equal to the ratio of nominal GDP to the nominal money stock, or:

P Y Y (1)
V 
M M
P
 Can also be interpreted as the ratio of nominal income to nominal
money stock OR the ratio of real income to real balances

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 The Income Velocity
Concept of velocity is important largely because it is a convenient
way of talking about money demand

• Demand for real balances is: = L(r, Y) (2)

Substituting into equation (1), velocity can be written as:

=
( , )

Money demand can be written as: , = × ℎ( )

Velocity of money is: =

( )

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 Measurement and Components of
Money Supply

As liquidity of an asset decreases, the interest yield increases.

– A typical economic tradeoff: in order to get more liquidity,
asset holders have to sacrifice yield

1. Reserve Money (M0)

(r Currency in circulation
+ ‘other’ deposits with RBI
+ Bankers’ deposits with RBI

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2. Narrow Money (M1)

Currency with the public

+ ‘other’ deposits with RBI
+ Demand deposits with banks

3. Broad Money (M3)

M1
+ time deposits with banks
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 Credit Creation
• Fractional-reserve banking & Credit creation by
commercial banks.

Deposit (money supply) Multiplier

1

Liquidity Ratio (CRR)

Change of money

Change of reserves
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 India’s GDP and Money Supply

Velocity Velocity
GDP M0 M1 M3 (M0) (M3) Multiplier M0/GDP
1950-51 104 15 20 24 6.96 4.42 1.57 14.36
1960-61 179 22 29 40 8.01 4.53 1.77 12.48
1970-71 476 48 74 110 9.88 4.32 2.29 10.12
1980-81 1496 195 234 558 7.69 2.68 2.87 13.00
1990-91 5862 878 929 2658 6.68 2.21 3.03 14.97
2000-01 21687 3033 3794 13132 7.15 1.65 4.33 13.99
2010-11 77841 13768 16383 65041 5.65 1.20 4.72 17.69
2015-16 137718 21807 26025 116176 6.32 1.19 5.33 15.83
2016-17 153623 19005 26820 127919 8.08 1.20 6.73 12.37
2017-18 170950 24188 32673 139626 7.07 1.22 5.77 14.15
2018-19 190101 27705 37103 154309 6.86 1.23 5.57 14.57
At current Price in ₹billion GDP/M0 GDP/M3 M3/M0 M0/GDP
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 How to control Money Supply?

• ‘Control M0 to control M3’ as money multiplier (m)

is not a policy variable.

• Money multiplier
Money supply (M) = money multiplier (m) 
monetary base (M0)

M3
Broad Money Multiplier (m) 
Monetary Base (M0)

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 Monetary Policy

RBI’s Mandate Vs Policy Stance

Preamble of the RBI Act, 1934

“to regulate the issue of Bank notes and keeping of reserves with a
view to securing monetary stability in India and generally to operate
the currency and credit system of the country to its advantage; to have
a modern monetary policy framework to meet the challenge of an
increasingly complex economy, to maintain price stability while
keeping in mind the objective of growth.”
 Monetary Policy: Objectives and Tools
Stable prices
OBJECTIVES Low unemployment
Rapid growth of GDP
(GOALS)
• Open Market Operations
(including Repo & Reverse Repo)
• Marginal Standing Facility (MSF)
• Bank Rate
INSTRUMENTS • Statutory Reserve Requirements(CRR)
• Secondary Reserves (SLR)
• RBI’s Credit to Development Banks
• Moral Suasion

INTERMEDIATE Exchange rate

TARGET Money supply
Interest rate

(ULTIMATE)
INFLATION
TARGET
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 How Interest Rates are Determined:
Combining the Demand and Supply of Money
(The Liquidity Preference Theory)

Ms Ms Ms Ms0
0 1 1

r0 r1

r1 r0 Md
Md

Money Money
An open market purchase shifts the An open market sale shifts the
supply of money to the right and supply of money to the left and
leads to lower interest rates. leads to higher interest rates.

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 Money – Price Relationship
The Money-Supply Growth Rule
• Quantity Theory of Money (QTM)

MV=PY

• Real Balance Equation

M M  
 L(Y , r );  kY r
P P
ln M  ln P  ln k   ln Y   ln r 20
 Money, Output and Prices

Central bank determines the money Y2 S

Supply, changing interest rates and
Investment, thereby affecting GDP
Y1
C
GDP
Ms1 Ms2
Investment, Saving
Interest rate

r1 Interest rate
A B
r2

Md I
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Money I1 I2 Investment
The Monetary Transmission Mechanism

AD>AS, Inflation

Contraction in Money supply

Higher interest rate

Fall in investment, etc

AD, Y and Prices fall 22

 Channels of Transmission
 The interest rate channel

 The credit channel

 The exchange rate channel

 The asset price channel

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 The Interest Rate Channel

Lower liquidity and credit

Higher interest rates

Lower investment Fall in asset value

Fall in AD Fall in wealth and C

Lower inflation, Production and employment 24

The Exchange rate Channel
Lower liquidity and credit

Higher interest rates

Uncovered interest parity

Weaker currency

Decline in imports
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 The Impossible Trinity
• It is not possible for the central bank to achieve the three objectives viz., manage
exchange rate, free capital flow, and manage interest rate simultaneously.

• Once the doors of capital flows are opened, market forces will determine the
exchange rate and interest rate.

• If central bank wants to have say in both exchange rate and interest rate, it will have
to place restrictions on the capital flow.

Free capital flow

The Inconsistent Trinity

At a certain time country
could have a combination
of any two of the three
conditions

Fixed exchange rate Independent monetary policy

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 Monetary Policy in India: Issues

• Conflict of targets: Money supply/exchange

rate/interest rate and price level.
• Investment behavior - insensitive to interest
rates.
• Central bank doesn’t have independence under
fixed exchange rate system.
• Fiscal-monetary policy nexus.
• External sector – the main cause of expansion
in money supply.
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 References
• DFS: Macroeconomics, Chapter 16 and 17
• “Money to smoke!”, handout
• “Money supply measures”, @google drive.
• “Interest rates and RBI’s key policy rates”, @google drive.
• “Monetary Transmission in India: Why is it important and why hasn’t it
worked well?”, Dr. Viral V Acharya, Deputy Governor, Reserve Bank of
India, 2017, @google drive.
• “The Taylor’s rule”, @google drive.
• “The transmission mechanism of monetary policy”, @google drive.
• “Understanding money and monetary policy: RBI’s policy rates, monetary
transmission and the relevance of monetary ratios”, Assignment-3.

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