Money: Slides Are Developed by DG. Do Not Distribute or Duplicate The Material

Money
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What is Money?
• Medium of Exchange: It is an item given by the buyers to sellers at the
time of purchasing goods and services.
• Unit of Account: People use it as an yardstick to quote the prices and
record debts.
• Store of Value: It is used as an medium to transfer purchasing power
from one period to the other.
• It can be argued that, similar to fiat money; assets like houses, bonds,
shares, gold can also be stored and used in future. But money
functions differently than other forms of assets because of liquidity.
Liquidity implies the ease of an asset to be converted into a medium
of exchange so that individual or a firm can buy with it anything at
any time. Compared to all assets, money has the highest liquidity.
• Standard of Deferred Payment: it serves as the basis for credit of any
loan as the standard for deferred payments. Deferred payments
mean those payments which are to be made in the future.
Types of Money
• Commodity Money: Commodity money is the simplest and the oldest
type of money. It takes the form of a commodity with intrinsic value.
Examples: gold coins, beads, shells, spices, etc.
• Fiat Money: Fiat money gets its value from a government order (i.e.,
fiat) or decree. The government of a country declares fiat money to
be legal tender and all economic agents within the administrative
boundary of the country have to accept it as a mode of payment. It
has almost no intrinsic value. Examples: coins and bills.
• Fiduciary Money: Fiduciary money is a promise by the issuer of to
exchange it back for a commodity or fiat money if requested by the
bearer. Unlike fiat money, it is not declared legal tender by the
government but is accepted based on confidence. Examples:
cheques, banknotes, or drafts.
• Commercial Bank Money: Commercial bank money is made out of
book money or created through fractional reserve banking.
Fractional reserve banking is a process where commercial banks give
out loans worth more than the value of the actual currency they hold
and with such debt, generated by commercial banks, can be
exchanged for “real” money or to buy goods and services.
Demand for Money

Why Money is Demanded?
• Transactions motive: To make transactions
• Precautionary motive: To take precaution against an uncertain
future.
• Speculative motive: As money can be stored an asset, demand for
money depends on both its rate of return and its opportunity cost. If
money is hold in the most liquid form, it provides zero rate of return
and often depreciates in value due to inflation. The opportunity cost
of holding money is the interest rate that can be earned by lending
or investing instead of holding it in the liquid form. The speculative
motive for demanding money describes a situation where holding
money is compared with the alternatives of investing or lending it in
some other asset.

Interest Rate
• Interest rate is the rate charged by a lender of money or credit to a
borrower. In short, from the borrower‟s point of view it is the „cost‟ of
borrowing, and from the lender‟s point of view it is the reward for
lending. Or, to put it into an even simpler way, the rate of interest is
the price of money.
• Real Interest Rate: A real interest rate is an interest rate that has been
adjusted to remove the effects of inflation to reflect the real cost of
funds to the borrower and the real yield to the lender or to an
investor.
• Nominal Interest Rate: A nominal interest rate refers to the interest
rate before taking inflation into account. Nominal can also refer to
the advertised or stated interest rate on a loan, without taking into
account any fees or compounding of interest.

Rate of Interest and
Money Demand
The demand curve of money shows
Rate of Interest the relationship between the
quantity of money demanded and
the market interest rate, all other
determinants remain unchanged
(M/P)d
Real Money Demand

Money Demand
Rate of Interest
Money demand is inversely related

with rate of interest.
r1
r2
(M/P)d
(M/P)1 (M/P)2
Real Money Demand
Money Demand
A liquidity trap is a situation,
Rate of Interest described in Keynesian economics,
in which, "after the rate of interest
has fallen to a certain level,
liquidity preference may become
virtually absolute in the sense that
almost everyone prefers holding
cash rather than holding a debt
which yields so low a rate of
Liquidity Trap interest.“
Under liquidity trap, monetary

r̅ (M/P)d policy becomes ineffective due to
very low interest rates combined
with consumers who prefer to save
rather than invest in higher-
Real Money Demand yielding bonds or other
Slides are developed by DG. Do not distribute or duplicate the material investments.
Supply of Money

Money Supply
Rate of Interest (M/P)s
Money supply is the total amount of
monetary assets available in an
economy at a specific time.
The supply curve of money shows the

relationship between the quantity
of money supplied and the market
interest rate when all other
determinants remain unchanged
Real Money Supply

Money Market Equilibrium

Money Market Equilibrium
Rate of Interest
(M/P)s
Equilibrium (M/P)s=(M/P)d
re
(M/P)d
Real Money Demand / Supply

Numerical
Suppose the demand function of the money is given by
Real Money Demand: (M/P)d = 1000 – 100r
Where r = interest rate in percentage; Nominal Money Supply(Ms) = 1000; and
Price Level (P) = 2.
a. Draw the graph of real money demand and real money supply.
b. What will be the equilibrium rate of interest (re)?
c. Assume the price level is fixed. What will happen to equilibrium rate of
interest if money supply (Ms) is increased to Rs.1200?
d. If RBI wants to increase the interest rate to 7%. What amount of money
supply should it set?

Monetary Policy

What is Monetary Policy?
• How the Central Bank influences the supply
of money and brings the nation out of either
a recession or inflationary period.
• Monetary policy is essentially a program of
action undertaken by the monetary
authorities generally the central bank, to
control and regulate the supply of money
with the public and the flow of credit with a
view to achieving the objectives of general
economic policy
Objectives of Monetary
Policy
• Maintain price Stability.
• Flow of credit to the productive sectors of
the economy.
• Stability for the national currency.
• Growth in employment and income.
• To promote and encourage economic
growth in the country.

Central Bank of the Country
– Reserve Bank of India
• Established In 1935 With a Share Capital of
Rs. 5 corers on the basis of the Hilton Young
Commission.
• The Share Capital was Divided into Rs. 100
each
• Fully paid up which was entirely owned by
private shareholders in the beginning.
• RBI was nationalized in 1949.

Appointed, not elected
• The RBI Governor is appointed by the Prime
Minister's Office (PMO) on the
recommendation of the union finance
minister as per Section 8(1)(a) of the Reserve
Bank of India Act, 1934.

Role of RBI

What does the RBI Do?
• Monetary Authority: Formulates, implements and monitors the
monetary policy for A) maintaining price stability, keeping
inflation in check ; B) ensuring adequate flow of credit to
productive sectors.
• Regulator and supervisor of the financial system: lays out
parameters of banking operations within which the country”s
banking and financial system functions for- A) maintaining public
confidence in the system, B) protecting depositors‟ interest; C)
providing cost-effective banking services to the general public.
• Regulator and supervisor of the payment systems: A) Authorises
setting up of payment systems; B) Lays down standards for
working of the payment system; C)lays down policies for
encouraging the movement from paper-based payment systems
to electronic modes of payments; D) Setting up of the regulatory
framework of newer payment methods; E) Enhancement of
customer convenience in payment systems; F) Improving security
and efficiency in modes of payment.
What does the RBI Do?
• Manager of Foreign Exchange: RBI manages forex under the
FEMA- Foreign Exchange Management Act, 1999. in order to
A) facilitate external trade and payment; B) promote the
development of foreign exchange market in India.
• Issuer of currency: RBI issues and exchanges currency as well
as destroys currency & coins not fit for circulation to ensure
that the public has an adequate quantity of supplies of
currency notes and in good quality.
• Developmental role: RBI performs a wide range of promotional
functions to support national objectives. Under this it setup
institutions like NABARD, IDBI, SIDBI, NHB, etc.
• Banker to the Government: performs merchant banking
function for the central and the state governments; also acts
as their banker.
• Banker to commercial banks: An important role and function
of RBI is to maintain the banking accounts of all scheduled
banks and acts as the banker of last resort.
• An agent of Government of India in the IMF.
Instruments of Monetary
Policy of RBI

Quantitive Instruments

Quantitive Instruments
1. Bank rate
2. Liquidity Adjustment Facility
3. Varying reserve ratios

1. Bank rate
• Definition: The rate at which RBI provides loan to the
commercial banks is called bank rate. This instrument is a key
at the hands of RBI to control the money supply in long term
lending.
• At present it is 4.25%.
• Increase in the bank rate will make the loans more expensive
for the commercial banks; thereby, pressurizing the banks to
increase the rate of lending. The public capacity to take
credit at increased rates will be lower, leading to a fall in the
volume of credit demanded.
• The reverse happens in case of a decrease in the bank rate.
This increases the lending capacity of banks as well as
increases public demand for credit and hence will
automatically lead to a rise in the volume of credit flowing in
the economy.

How does bank rate affect the
money supply?
Bank Rate Credit Demand
Bank Rate Credit Demand
Slides are developed by DG. Do not

distribute or duplicate the material
2. Liquidity Adjustment
Facility (LAF)
Reserve Bank of India‟s LAF helps banks to adjust their daily

liquidity mismatches. LAF has two components:
i. Repo (repurchase agreement) rate and
ii. Reverse repo rate.
One more scheme has been introduced by RBI for reducing

volatility in the overnight lending rates in the inter-bank market
and to enable smooth monetary transmission in the financial
system i.e., Marginal Standing Facility (MSF)

2(i). Repo Rate
• Definition: Repo (Repurchase) rate is the rate at which the RBI

lends short-term money to the banks against securities. When the
repo rate increases borrowing from RBI becomes more expensive.
Repo rate is always higher than the reverse repo rate.
• At present it is 4.00%
• Increase in the repo rate will make the loans more expensive for
the commercial banks; thereby, pressurizing the banks to increase
the rate of lending. The public capacity to take credit at
increased rates will be lower, leading to a fall in the volume of
credit demanded.
• The reverse happens in case of a decrease in the repo rate. This
increases the lending capacity of banks as well as increases
public demand for credit and hence will automatically lead to a
rise in the volume of credit flowing in the economy.

How does repo rate affect the
money supply?
Repo Rate Credit Demand
Repo Rate Credit Demand

Bank Rate vs. Repo Rate
Bank Rate Repo rate
It is the rate charged by the central It is the rate charged by the central
banks at the time of taking loan bank for repurchasing securities
sold by commercial banks to the
central bank
No collateral is involved Collateral like securities,
agreements, bonds etc. are involved
It is always higher than repo rate It is always lower than bank rate
Tenure is longer than a month Loan tenure can be overnight, open
or flexible
No repurchasing involved Purchase agreements exists

2(ii). Reverse Repo Rate
• Definition: It is the exact opposite of repo. In a reverse repo

transaction, banks purchase government securities form RBI
and lend money to the banking regulator, thus earning
interest. Reverse repo rate is the rate at which RBI borrows
money from banks. The banks use this tool when they feel that
they are stuck with excess funds and are not able to invest
anywhere for reasonable returns.
• An increase in reverse repo rate means that commercial
banks will get more incentives to park their funds with the RBI,
thereby decreasing the supply of money in the market.

How does reverse repo rate affect
the money supply?
Reverse Repo Rate Money Supply
Reverse Repo Rate Money Supply

3. Varying reserve ratios
• The reserve ratio determines the reserve requirements that

banks are liable to maintain with the central bank. It has two
components:
i. Cash Reserve Ratio (CRR) and

ii. Statuary Liquidity Ratio (SLR)

3(i). Cash Reserve Ratio
• Definition: Cash Reserve Ratio (CRR) refers to the minimum

amount of funds in cash(decided by the RBI) that a
commercial bank has to maintain with the Reserve Bank of
India, in the form of deposits. An increase in this ratio will
eventually lead to considerable decrease in the money
supply. On the contrary, a fall in CRR will lead to an increase in
the money supply.
• At present it is 3%
• If RBI increases the CRR, lowering the loanable funds available
with the banks. This, in turn, slows down investment and
reduces the supply of money in the economy. As a result, the
growth of the economy is negatively impacted.

How does CRR affect the money
supply?
CRR Money Supply
CRR Money Supply

3(ii). Statuary Liquidity Ratio
• Definition: Statutory Liquidity Ratio (SLR) is the minimum

percentage of deposits that a commercial bank has to
maintain in the form of liquid cash, gold or other securities. It is
basically the reserve requirement that banks are expected to
keep before offering credit to customers.
• At present it is 18%
• By increasing the level of SLR, the RBI can decrease liquidity
with the commercial banks, resulting in decreased investment.
This is done to slow down growth and money supply.

How does SLR affect the money
supply?
SLR Money Supply
SLR Money Supply

Qualitative Instruments

1. Margin requirement
• Lending Margin: The banks provide loans only upto a certain
percentage of the value of the mortgaged property. The gap
between the value of the mortgaged property and amount
advanced is called „lending margin‟.
• Commercial banks gives loans to their customers against some
security or securities offered by the borrower and acceptable
to banks. However, the commercial banks do not lend up to
the full amount of the security but less than the value of the
security.
• The margin requirements against specific securities are
determined by the Central Bank. A change in margin
requirements will influence the flow of credit.
• For instance, if margin requirement is 60% and the of the value
of the security of the pledger is Rs 10,000, then only 40% of the
value, i.e. Rs 4,000 will be offered as loan.
• In case of recession in a particular sector, the central bank
encourages borrowing by lowering margin requirements.
How does margin requirement
affect the money supply?
Margin Requirement Money Supply
Margin Requirement Money Supply

2. Credit rationing
• It implies to limit the maximum amount of loans and advances.
In other words, to fix a ceiling on the maximum available
amount of credit, for specific categories of loans and
advances.
• RBI fixes a credit amount to be granted for commercial banks.
Credit is given by limiting the amount available for each
commercial bank.
• For certain purposes, the upper credit limit can be fixed, and
banks have to stick to that limit.
• This helps in lowering the bank's credit exposure to unwanted
sectors.

How does credit rationing affect
the money supply?
Credit Limit Money Supply

Extending the maximum amount
Credit Limit Money Supply

Reducing the maximum amount

3. Moral Suasion
• In India, from 1949 onwards, the Reserve Bank successfully
practicing moral suasion to control the commercial banks to
fall in line with credit policies.
• Combination of persuasion and pressure
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Other Measures

Marginal Standing
Facility (MSF)
• Definition: Marginal Standing Facility (MSF) was introduced by
RBI in the Monetary Policy of 2011-12.
• It is a window for banks to borrow overnight from the Reserve
Bank of India in an emergency when inter-bank liquidity dries
up completely.
• The MSF would be a penal rate for banks and the banks can
borrow funds by pledging government securities within the
limits of the statutory liquidity ratio SLR.
• Due to the increase in the rate of MSF, borrowing becomes
expensive for the banks and as a result, the loans get
expensive for the borrowers due to the low obtainability of the
rupee.

Repo vs. MSF
Repo Rate MSF
It is applied to loans given to banks It is applied to loans given to banks

to meet their short-term financial for overnight lending
needs
Money is lent by RBI to the Money is lent by RBI to the

commercial banks, who apply for it scheduled banks
It involves selling of bank’s It involves providing government

securities as collateral to RBI along securities as collateral
with a repurchase agreement

Open Market Operation
Definition: An open market operation (OMO) is an activity by a
central bank to give (or take) liquidity in its currency to (or from)
a bank or a group of banks.
If RBI sells securities in the money market, private and commercial

banks and even individuals buy it. This leads to a reduction in the
existing money supply as money gets transferred from
commercial banks to the RBI. On the other hand, when RBI buys
securities from the commercial banks, the commercial banks that
sell receive the amount they had invested in RBI before.
It includes outright buying or selling of government securities.

(Permanent).

How does OMO affect the money
supply?
Selling Bonds Money Supply
Selling bonds takes money out of circulation
Buying Bonds Money Supply

Buying bonds puts money back into circulation

Market stabilization schemes
• This instrument was introduced in 2004.

• Surplus liquidity of a more enduring nature arising from large
capital inflows is absorbed through sale of short-dated
government securities and treasury bills. The cash so mobilised
is held in a separate government account with the Reserve
Bank.

Conclusions

Conclusions
To excuse from recession, the RBI encourages

people to spend more by increasing the
money supply.
To combat inflation, the RBI discourages

people from spending by reducing the money
supply.

Monetary Policy during a
Recession
Goal:
Increase Money Supply
Actions:
• Decrease Bank Rate
• Decrease Repo Rate
• Decrease Reverse Repo Rate
• Decrease CRR
• Decrease SLR
• Decrease Margin Requirement
• Higher Credit Limit
• Buy Bonds
Called Easy Money Policy

Monetary Policy during Inflation
Goal:
Decrease spending and the money supply
Actions:
• Increase Bank Rate
• Increase Repo Rate
• Increase Reverse Repo Rate
• Increase CRR
• Increase SLR
• Increase Margin Requirement
• Lower Credit Limit
• Sell Bonds
Called Tight Money Policy


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Money

Slides are developed by DG. Do not distribute or duplicate the material

Slides are developed by DG. Do not distribute or duplicate the material

Slides are developed by DG. Do not distribute or duplicate the material

Slides are developed by DG. Do not distribute or duplicate the material

Real Money Demand

Money demand is inversely related

Under liquidity trap, monetary

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The supply curve of money shows the

Real Money Supply

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Real Money Demand / Supply

Slides are developed by DG. Do not distribute or duplicate the material

Slides are developed by DG. Do not distribute or duplicate the material

Slides are developed by DG. Do not distribute or duplicate the material

Slides are developed by DG. Do not distribute or duplicate the material

Slides are developed by DG. Do not distribute or duplicate the material

Slides are developed by DG. Do not distribute or duplicate the material

Slides are developed by DG. Do not distribute or duplicate the material

Slides are developed by DG. Do not distribute or duplicate the material

Slides are developed by DG. Do not distribute or duplicate the material

Slides are developed by DG. Do not distribute or duplicate the material

Bank Rate Credit Demand

Bank Rate Credit Demand

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Reserve Bank of India‟s LAF helps banks to adjust their daily

One more scheme has been introduced by RBI for reducing

Slides are developed by DG. Do not distribute or duplicate the material

• Definition: Repo (Repurchase) rate is the rate at which the RBI

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Repo Rate Credit Demand

Repo Rate Credit Demand

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• Definition: It is the exact opposite of repo. In a reverse repo

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Reverse Repo Rate Money Supply

Reverse Repo Rate Money Supply

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• The reserve ratio determines the reserve requirements that

i. Cash Reserve Ratio (CRR) and

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• Definition: Cash Reserve Ratio (CRR) refers to the minimum

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CRR Money Supply

CRR Money Supply

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• Definition: Statutory Liquidity Ratio (SLR) is the minimum

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SLR Money Supply

SLR Money Supply

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Slides are developed by DG. Do not distribute or duplicate the material

Margin Requirement Money Supply

Margin Requirement Money Supply

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Credit Limit Money Supply

Credit Limit Money Supply

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Inform Warning De-recognition

•Guidelines •Notice for •Dis-owning