Money, Monetary Aggregates

and Monetary Policy

Smita

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 Money
• India follows Minimum Reserve System.
• Monetary Aggregates used to define Money
in India are –
1. M1 – Narrow Money
2. M2
3. M3 – Broad Money
4. M4

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 Old Monetary Aggregates
The Reserve bank of India uses 4 concepts to define the ‘Money
supply’ in India. These ‘Money Supply’ terms are also called as Money
Stock Measures OR Monetary Aggregates.
They are as follows:
• M1: This is Currency with the public + Demand Deposits with Banks
+ OD with RBI. It is also called as Narrow Money.
• M2 : M1 + Post office Savings Deposits. It is also termed as Narrow
Money
• M3 : M3 is broad Money i.e. M1 + Aggregate Deposits of the Public
with Banks which is made up of Demand Deposits and Time
Deposits.
• M4 : M4 refers to M3 and Post Office Deposits. It is also termed as
Broad Money.

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 What is Reserve Money?
• Reserve money is also called central
bank money, monetary base, base money,
high-powered money. In the most simple
language, Reserve Money is Currency in
Circulation plus Deposits of Commercial Banks
with RBI plus 'other' deposits with RBI.

• MO (Reserve Money) = Currency in Circulation

+ Bankers' Deposits with the RBI + 'Other'
Deposits with RBI
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 You Tube Video
• https://youtu.be/IMkFc863Nqk
• https://youtu.be/W3k7Gw39OHI

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 New Monetary Aggregates
• In view of growth of Financial Markets over the
years, need was felt to bring in various institutions
that hold money or contribute to liquidity in
financial markets within the definition of money
supply in India. Some of these entities are:
• ‘Financial Institutions’ other than banks. Example
are: IFCI, SIDBI etc.
• NBFC – Non Banking Financial Companies

Hence New Monetary Aggregates were proposed

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and are accepted.
 New Monetary Aggregates
( Based on Y.V. Reddy Committee Report)
• M1 = C + DD + OD (Same as earlier definition)

• M2 = M1 + CD’s (certificate of Deposits) issued by

banks + Term Deposits maturing in a year.

• M3 = M2 + Term Deposits of Over a year + Call/Term

borrowings of banks

• M4 = Abolished now.

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 Liquidity Aggregates in India
• L1 = M3 + All Deposits with post Offices

• L2 = L1 + Term deposits with term lending

institutions + CD’s issued by FI’s.

• L3 = L2 + Public Deposits with NBFC’s.

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 Factors affecting Money Supply
Factors affecting Money Supply Money Supply is affected mainly
by two factors viz. Monetary base and Money Multiplier.
• Monetary Base: As the reserve money changes, money supply
also changes in the same direction. This means if there is
more of reserve money in the system, money supply
increases.
• Money Multiplier: Money Multiplier is the ratio of the Narrow
Money (M1) or the Broad Money (M3) to Reserve Money.
• Supply of money is product of Money Multiplier (m) and the
amount of high powered money or the Reserve money.

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 Credit Creation Capacity of Banks
• Money supplied by commercial banks to economy is called
credit money.
• Commercial banks create credit by advancing loans.
• They lend money to individuals and businesses out of
deposits accepted from the public.
• However, commercial banks cannot use the entire amount of
public deposits for lending purposes.
• They are required to keep a certain amount as reserve with
the central bank for serving the cash requirements of
depositors. After keeping the required amount of reserves,
commercial banks can lend the remaining portion of public
deposits
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 Credit Creation (contd.)
• Suppose you deposit Rs. 10,000 in a bank A, which is the
primary deposit of the bank. The cash reserve requirement of
the central bank is 10%. In such a case, bank A would keep Rs.
1000 as reserve with the central bank and would use
remaining Rs. 9000 for lending purposes.
• The bank lends Rs. 9000 to Mr. X by opening an account in his
name. Now, Mr. X writes a cheque of Rs. 9000 in favor of Mr. Y
to settle his earlier debts.
• Mr. Y has account with Bank B. Bank B Receives Rs. 9000. It
will maintain 10% of it as Cash Reserve and will lend
remaining Rs. 8,100

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 Multiple deposit expansion process
Acquired reserves Required Excess New money
Bank and deposits reserves reserves created

A 10000 1000 9000 9000

B 9000 900 8100 8100
C 8100 810 7290 7290
D 7290 729 6561 6561
E 6561 656.1 5904.9 5904.9
F 5904.9 590.49 5314.41 5314.41
 Credit Creation Process
❑Total Credit Creation = Original Deposit * Credit Multiplier
Coefficient

❑Credit multiplier coefficient= 1 / r where r = cash reserve

requirement also called as Cash Reserve Ratio (CRR)
❑Credit multiplier co-efficient = 1/10% = 1/ (10/100) = 10
❑Total credit created = 10,000 *10 = 100000

❑If CRR changes to 5%,

Credit multiplier co-efficient = 1/5% = 1/ (5/100) = 20
Total credit creation = 10000 * 20 = 200000

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MONETARY POLICY

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 Monetary Policy
• Monetary policy is the macroeconomic policy
laid down by the central bank. It involves
management of money supply and interest
rate and is the demand side economic policy
used by the government of a country to
achieve macroeconomic objectives like
inflation, consumption, growth and liquidity.

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 Monetary and Credit Policy Tools
• CRR
• SLR
• Bank Rate
• Open market Operations and MSS (Market
Stabilization Scheme)
• Repo transactions - LAF (initiated from 2000)
• Banking Guidelines

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 CRR – Cash Reserve Ratio
• CRR is the amount of funds that banks have to maintain with
the Reserve Bank of India (RBI) at all times. If the central bank
decides to increase the CRR, the amount available with the
banks for disbursal comes down.
• The RBI uses the CRR to drain out excessive money from the
system or vice versa.
• Commercial banks are required to maintain an average cash
balance with the RBI as stipulated under CRR guidelines of
RBI.
• Minimum level of CRR is 3% of the total of Net Demand and
Time Liabilities (NDTL). The RBI is empowered to increase the
CRR to ≤20% of the NDTL.
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 CRR- NDTL
• The NDTL (Net Demand and Time Liabilities) is
the total volume of liabilities on which the
bank needs to maintain CRR with the RBI.
• DTL includes demand liabilities like current
account deposits, savings account deposits,
margins held against L/Cs & guarantees,
outstanding TT/MT/DD and call money
borrowings.
• Time liabilities include fixed deposits, cash
certificates, recurring deposits etc. 18
 SLR
• Every bank must have a specified portion of their Net
Demand and Time Liabilities (NDTL) in the form of
cash, gold, or other liquid assets by the day’s end
(Government securities and Government approved
Securities).
• The ratio of these liquid assets to the demand and time
liabilities is called the Statutory Liquidity Ratio (SLR).

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 Bank Rate
• Bank rate is the rate charged by the central bank for
lending funds to commercial banks.
• In other words it is the rate of interest charged by
the central bank on the loans they have extended to
commercial banks and other financial institutions is
called “Bank Rate”.
• In case of extending facility at Bank Rate, the RBI
does no repurchasing agreement, no securities are
sold or collateral is involved.
• Bank Rate is usually higher than Repo Rate.
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 Open Market Operations
• Open market operations or OMOs are conducted by the
Reserve Bank of India (RBI) by way of sale and purchase of G-
Secs (government securities) to and from the market with an
objective to adjust the rupee liquidity conditions in the
market on a durable basis.
• When the Reserve Bank feels that there is excess liquidity in
the market, it resorts to sale of securities thereby sucking out
the rupee liquidity.
• Similarly, when the liquidity conditions are tight, RBI may buy
securities from the market, thereby releasing liquidity into the
market.

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MSS – Market Stabilization Scheme
• Open Market Operations (OMO) is buying and
selling of Government securities to manage
money supply in the economy. Thus, it is used
to both inject and withdraw liquidity.
Moreover, these securities are a part of
Government borrowing.
• On the other hand MSS is only selling of
Government securities to withdraw excess
liquidity. The money raised through the selling
of securities is kept in a separate account
known as MSS account. 22
 MSS
• The Market Stabilization Scheme (MSS) was launched in
April 2004. During 2002-2004, there were huge capital
inflows into India. This led to an appreciation of the
rupee (because demand for Indian rupee increased).
Appreciation of rupee is not good for exports as it makes
exports more expensive.
• To combat this, the RBI sold Government securities to
withdraw the excess liquidity. The selling of Government
securities depleted the limited stock of securities held by
the RBI.
• This withdrawal of excess liquidity is also known as
sterilisation.
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 What is LAF?
• A liquidity adjustment facility (LAF) is a tool used in
monetary policy, used by the Reserve Bank of India
(RBI), to enable banks to borrow money through
repurchase agreements (repo) or to enable banks to
lend to the RBI using reverse repo contracts.

• This arrangement manages liquidity pressures and

ensures basic financial-market stability in short run.

• The short run here refers to period of 1 t0 14 days.

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 What is Repo Rate?
• The rate at which the RBI lends money to
commercial banks is called repo rate. It is an
instrument of monetary policy. Whenever
banks face a shortage of funds, they can
borrow from the RBI as per the repo rate.

A reduction in repo rates helps banks get

money at a cheaper rate and vice versa. The
repo rate in India is similar to the discount
rate in the US. 25
 What is Reverse Repo
• Reverse repo rate is the rate at which
the RBI borrows money from commercial banks.
Banks are always happy to lend money to the RBI
since their money is in safe hands and earns good
interest.
• An increase in reverse repo rate can prompt banks
to park more funds with the RBI to earn higher
returns on idle cash. It is also a tool which can be
used by the RBI to drain excess money out of the
banking system. 26
y Monetary Policy

Monetary Policy Rate Changes introduced

on March 27, 2020

Policy rate New Rate Previous Rate Change in Basis points (bps)

Policy Repo Rate 4.40 % 5.15% 75

Reverse Repo Rate 4% 4.90% 90

Marginal Standing
4.65% 5.40% 75
Facility Rate

Bank Rate 4.65% 5.40% 75

CRR 3% 4% 100
SLR 18.25% 18.25% – 27
 You Tube Videos on Monetary
Policy
• https://youtu.be/Gm8LZcTUmf8
• https://youtu.be/QAefM8OauTk
• https://youtu.be/CwRNDLHgl3g

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