Coursework: Macroeconomics &

Policy
By
Dr. Manas Paul
IIM Kashipur Term II PGDM 2020-22
Why interest rate not money supply?
Easier to measure

Central Banks belief about prevalence of LM

shocks
..hence interest rates stabilizes income better than
targeting money supply

Strictly for use of students of IMT only and

not for any other purpose
Monetary Transmission Mechanism
1. Central Bank announces short term interest rate that
depends upon its objectives and state of the economy
2. Central Bank undertakes daily operations to meet its
interest-rate target
3. Central Bank’s new interest rate target and market
expectations about future financial conditions help
determine the entire spectrum of short and long term
interest, asset prices and exchange rates
4. Changes in interest rate, credit conditions, asset prices,
and exchange rates affect investment, consumption and
net exports
5. Changes in investment, consumption, and net exports
affect the path of output and inflation through AS-AD
mechanism
 Impediments To:
Monetary Policy Transmission in India
 Statutory SLR
 Lazy Banking
 Low credit demand
 Rising NPA’s
 Fiscal dominance
 Small savings schemes
Post office deposits, PPF, Savings Certificates
 Interest rate subventions, debt waiver/relief
 Tax saving mutual funds
Strictly for use of students of IMT only and
not for any other purpose
 Financial System
• Financial System: Circulatory System that links
together goods, services, and finance in domestic and
international markets
• It is through money and finance that households and
firms borrow from and lend to each other in order to
consume and invest
• Financial System comprises: Market and firms, other
institutions, which carry out the financial decisions of
households, businesses, and governments….
• ….money market, markets for fixed interest assets like
bonds or mortgages, stocks markets for ownership of
firms, foreign exchange markets…
 Households purchases Firms sell bonds or has
government bond or initial public offerings
stocks Financial
(IPO) of stocks
Markets

Savers Investors

Financial
Intermediaries

Household deposits Small and big

monthly salary into businesses borrows
checking account from banks to invest
Savers & investors transfers funds across time, space and sectors through financial markets
and intermediaries
Some flows goes directly through financial markets (like buying stocks), while others
(purchasing units of MFs, or depositing money in checking accounts) go through financial
intermediaries
Major Financial Institutions
Commercial
Banks

Security Insurance
Financial
brokers, and pension
dealers…etc Institutions funds

Money
Market and
Mutual
funds
 Functions of Financial Systems
1. Transfers resources across time, sectors, regions
2. Manages risks for the economy – transferring
risks from those who need to reduce their risks
to others who are better suited to weather them
3. Pools and subdivides funds
4. Function as clearing house – facilitates
transactions between payers (purchasers) and
payees (sellers)…write a check to buy a new
computer, a clearinghouse will debit your bank
and credit the bank of the company selling the
computer
 Major Financial Assets
• Financial Assets: Claims by one party against another party
• Money: Very special asset – medium of exchange, unit of account & store
of value,
• Savings Accounts: deposits with bank or credit institutions, at times
guaranteed by government, with fixed principal value and interest rate
that could be fixed or variable
• Credit Mkt Instruments: Bonds and instruments of varied degrees of risks
• Common Stocks: Ownership right to Companies
• Money Mkt funds and MFs : funds held in short term assets or stocks
those could be subdivided into fractional shares and bought by small
investors
• Pension Funds: Long term investments drawn down during retirement
years
• Financial Derivatives: Whose value is derived from an underlying asset
 Special Case of Money
• Each currency note or coins has minimal intrinsic value
• They are useless unless we get rid of it
• However, money is anything by useless…
• …monetary policy is one of two most important tools
to stabilize business cycle
• The central bank uses its control over money, credit,
and interests rate to encourage growth when the
economy slows …..
• …..and slow growth when inflationary pressure rise
• In a well managed financial system output grows
smoothly and prices are stable
 Evolution of Money: Barter
• Money is anything that serves as a commonly accepted medium of
exchange
• During a world tour during the 1880s by the French singer,
Mademoniselle Zelie, one stop was a theater in the Society Islands,
part of French Polynesia in the South Pacific. She performed for her
usual fee, which was one-third of the receipts. This turned out to be
three pigs, 23 turkeys, 44 chickens, 5000 coconuts, and
"considerable quantities of bananas, lemons and oranges." She
estimated that all of this would have a value in France of 4000
francs… As Mademoiselle could not consume any considerable
portion of the receipts herself, it became necessary in the
meantime to feed the pigs and poultry with the fruit.
• Exchange through barter contrasts with exchange through money,
as pigs, turkey and lemons are not generally acceptable monies that
we or Mademoniselle Zelie can use for buying things….
 Disadvantages of Barter
• Barter is better than no trade at all…but face
grave disadvantages….
• …cannot operationalize an elaborate division of
labour, hence specialization and trade
• Not divisible into small change
• Moreover, in a barter system there has to be a
double coincidence of wants….
• …unless a hungry rickshaw puller happens to find
a farmer who has both food as well as the desire
to ride, under barter no one can make a direct
trade
Evolution of Money: Commodity
• Money as a medium of exchange first came into
human history in the form of commodities..
• A great variety of commodities served as money
at one time or the other: cattle, olive oil, beer,
wine, copper, iron, silver, gold, diamonds,
cigarettes and whether you believe it or not even
“Ramen”
• https://www.youtube.com/watch?v=PLt9fRYT92
M&ab_channel=Vox
 Issues with Commodity Money
• Commodity money had both some advantages and disadvantages…
• Cattle are not divisible into small change…Beer does not improve with
keeping…
• Olive oil can be a nice liquid currency minutely divisible but rather messy
to handle
• By 18th century money was almost exclusively limited to metals like gold
and silver…
• …meant these forms of money had intrinsic value in themselves…unlike
paper currency did not need any government guarantee
• But metallic currencies had their own shortcomings…needed scarce
resources to dig it out....
• ….moreover it might become abundant simply because of discoveries of
ore deposits…leading to unstable currency system
• Advent of monetary control by Central Banks, has led to a much more
stable currency system….
• Intrinsic value of currency is now the least important feature…
 Modern Money: Paper Currency
• Age of commodity money gave way to paper
money…devoid of intrinsic value
• Now money is not wanted for its own sake but the things it
can buy…
• We use money by getting rid of it…
• It is has become widespread because it is a convenient
medium of exchange…
– Easily carried and stored
– Value can be protected from counterfeiting by careful engraving
– Pvt individuals can not create money keeping it scarce
– Given this limitation on supply it has its value
• Paper money issued by Govts was gradually overtaken by
bank money – Checking Accounts
 Ultramodern Money
• Move towards cashless society….
• Rising importance of Electronic Money
• Digital currencies…are they true money?
• As the Governor of the Bank of Japan, Mr. Haruhiko Kuroda, once
said: “Bitcoin is being traded for investing or for speculation”.
Similar opinion was also expressed by the vice president of the
European Central Bank (ECB), Mr. Vitor Constancio, who said that
“bitcoin is not a currency but sort of a tulip”, alluding to the price
bubble of the Dutch tulip mania in the 17th century… Jens
Weidmann, the President of the Deutsche Bundesbank, highlighted
that the development of bitcoin has a noticeably speculative
character. Australia’s RBA Governor, Philip Lowe, was certainly the
harshest in expressing negative position on bitcoin arguing that the
asset is more likely to appeal to criminals than consumers (Lam,
2017).
 Are digital currencies true money?
• Unlike with fiat money they have a high cost of production reflecting the
need for large amount of energy needed to power computers those solves
cryptographic puzzles
• Main function of money is a means of payment, have digital currencies
taken over this function….
• Moreover, no monetary authority or government stands behind bitcoin or
any other crypto currency…there exists not protection in case of relevant
technological platform malfunction either…
• …payments in these currencies are minor….
• Digital currencies still do not perform the function of the measure of value
as we do not have products who value is expressed in digital currencies….
• Moreover, it also lacks the other function of money the store of
value…when you have money you can expects its value to remain nearly
the same excluding inflation in the near future, whereas the value of
digital currencies in future cannot be estimated by anyone….

Nikola Fabris: Cashless Society – The future of Money or a Utopia? Journal of Central Banking
Theory and Practice, 2019, 1, pp. 53-66
 Components of Money Supply
• Main component of money supply M1 also known as
Transactions Money…
• Generally it consists of…
• 1. Currency: Coins and paper money held outside the
banking system. It is not backed by gold or silver hence
they are fiat money. However they are legal tender
which must be accepted for all debt public and private.
• 2. This is the other component which is Bank Money.
This consists of funds, deposited on banks and other
financial institutions on which one can write checks
and withdraw money on demand…. i.e. demand
deposits
 Are Credit Cards Money?
• Credit Card is an easy but expensive way to
borrow money. When paying with a credit
card you are promising to pay the credit card
company – with money – at a later date
 Demand for Money: Transactions DD
• Transactions Demand for Money: Arises due
to the difference in the timing of income and
expenditures…
• Salary at the beginning of the month by
expenditure spread out over the month…
• Will transactions demand for money change if
all prices and income double?
 Demand for Money: Asset DD
• In addition to transaction demand money there is
asset demand for money…
• …basically to park the excess of earnings over
expenditure into assets of choice where the value
of money grows over time…
• However, in case of breakdown of investors
confidence on the financial system or when
interest rate is near zero, people might like to
hold money instead as any asset - liquidity trap
• …liquidity trap terrifies central bankers as they
loose their ability to affect interest rates
 Now lets look at Money Supply…
• Money supply is the outcome of the
interaction between Central Bank and
Commercial Banks
• Commercial Banks play a crucial step in the
monetary transmission process…
• A first step to understand the process is to
understand the balance sheets of Central Bank
and Commercial Banks
 Example: BS of Commercial Banks
Assets Liabilities and net worth
Reserves 43 Checking deposits 629
Loans 6250 Savings & Time 5634
Deposits
Investments 2265 Other Liabilities 2643
Other Assets 1404 Net Worth (Capital) 1056
Total 9961 Total 9961

Checking deposits are an important component of M1

Reserves are held primarily to meet legal requirements
Ratio of liabilities to networth is called the leverage ratio
Highly leveraged financial institutions produce systematic risk if the value of their
assets deteriorate
NOTE RESERVES ARE A FRACTION OF TOTAL DEMAND AND TIME LIABILITIES
 Innovation of Fractional Reserve
Banking
• Goldsmith Banks soon realized that they do
not need to 100% of their gold as reserves
against their notes and deposits
• People do not come to redeem their note at
the same time
Money Supply : How it is Defined ?  may temporarily hold RBI profits
M1 = Currency with the Public + Demand Deposits  Subscription to State govt loans
pending allotment
with Banks + “Other Deposits” with RBI • Post office deposits with RBI

M3 = M1 + Time Deposits with Banks

( i.e., currency with public + all bank deposits )
Expositions about money supply here onwards, centers around
M3 .

There is also M2 and M4

M2 = M1 + post office saving deposits
M4 = M3 + all post office deposits
But post office deposits are not treated as part of money supply in the
discussion that follows.
“Other Deposits” with RBI comprises of demand deposits held with the RBI
by international agencies, financial institutions, state governments etc.
This is a very small amount– so small, that it can be ignored.

20th October 2015 25

 Money Supply Process
• To simplify the discussion on the money supply process, we
will ignore “other deposits” from the definition of money .
• The simplified definition of money supply will then be as
follows : M = C + D , where M is money supply, C is
currency ( notes and coins ) held by the public, and D stands
for bank deposits.
• If ‘a’ is the fraction of money held by the public in the form
of currency, then 1-a is the fraction that constitutes bank
deposits i.e. M = C (=aM) + D(=(1-a)M)
∆𝑀 𝑠 : 𝑅𝑒𝑙𝑎𝑡𝑒𝑑 𝑡𝑜 𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑅𝐵𝐼 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦

Balance Sheet of Reserve Bank of India (RBI)

Assets Liabilities
Monetary
Financial Assets Monetary Liabilities base (MB)

a. Net RBI Credit to the Government a. Currency

b. RBI Credit to Banks - In circulation with Public
c. RBI Credit to Commercial Sector - Vault Cash
d. Net Foreign Exchange Assets of RBI b. Reserves (Banks’ Deposits with RBI)
-Statutory Reserves
- Excess Reserves

Other Assets Non-Monetary Liabilities

https://newsroom24x7.com/liabilities-of-reserve-bank/
 Monetary Base = High Powered Money
• Monetary Base (MB) / ‘high-powered money”/ reserve money
= currency in circulation with the public + reserves .
• Reserves are equal to vault cash + banks’ deposits with RBI.
• That is, MB is nothing but “monetary liability of RBI” in the RBI’s
balance sheet.
• RBI can increase or decrease MB by increasing or decreasing its
financial assets .
• An increase in MB leads to a further increase in money supply
through the banking system such that the final increase in M3
is a multiple of the increase in MB.
 How can 𝑀𝐵 Change?
RBI decides to increase Balance Sheet of Reserve Bank of India (RBI)
Monetary Base has
Money supply by OMO of
increased by Rs. 100 Assets Liabilities
Rs. 100
Financial Assets Monetary Liabilities

a. Net RBI Credit to the Government a. Currency

b. RBI Credit to Banks - In circulation with Public
c. RBI Credit to Commercial Sector - Vault Cash
d. Net Foreign Exchange Assets of RBI b. Reserves (Banks’ Deposits with RBI)
RBI receives Govt Bond -Statutory Reserves
RBI credits Bank A’s
from a financial - Excess Reserves
account with it by Rs. 100
institution against a Other Assets Non-Monetary Liabilities

cheque of Rs. 100 (RBI Liability goes up by

Rs. 100)
(RBI asset goes up)

The institution deposits

its receipt with its Bank A deposits the
commercial Bank : cheque with RBI for
clearance
Bank A
 ∆MB kicks in money multiplier

Suppose CRR is 10% so it Recipients of Rs. 90

Bank A’s Reserve
is excess reserves of Rs. deposits its in their bank
increases by Rs. 100
90 which it loans out say Bank B

Bank B now finds At the end of trading

holding excess Reserves period, RBI debits Bank
of Rs. 81 which it loans A’s balances with Rs. 90
…and the process goes and credits bank B’s
on balances with Rs. 90
 Value of money multiplier
M = C + D ; where M is broad money, M3 , C is currency in
circulation , D is bank deposits
This equation can be rewritten as :
M = (C/D + 1) D (1)
MB = C + R , where MB is monetary base , C is currency in
circulation, R is reserves ( vault cash + banks’
deposits with RBI )
MB = ( C/D + R/D ) D (2)

• C/D = currency deposit ratio is a behavioural parameter. In a developing

country like India, this ratio would tend to come down, with financial sector
development.

• R/D is a policy variable , i.e. CRR

 Value of money multiplier…..cont..
M = (C/D + 1) D (1)
MB = ( C/D + R/D ) D (2)
Then money multiplier “m”:
m = M / MB = (C/D + 1) / ( C/D + R/D ) (3)
An increase in C/D reduces ‘m’ ; an increase in R/D also lowers ‘m’
A decrease in C/D increases ‘m’ ; a decrease in R/D also increases ‘m’
M = m x MB (4)
That is, M is a multiple ‘m’ of MB
Given ‘m’ , an increase in MB accelerates growth in M.
Given MB, an increase in ‘m’ can accelerate growth in M.
• For C/D = 0.20 and R/D = 0.10 ,
m = (C/D + 1) / ( C/D + R/D ) = 1.20 /0.30 = 4.00
• Hence, for a Rs 100 increase in MB , the increase in M is of
Rs 400 ( and not Rs 1000, which would be the case
if C/D was equal to zero. )
 Some Caveats Though…
• All money does not get deposited.
• Public holds part of the money as cash outside the banks, the extent
depending upon public’s preferences for currency over deposit.
• In the money supply process then, in each round, some of the extra
money will leak out of the banking system, and the overall money
multiplier will come down.
• In the extreme case, if the entire increase in the MB of Rs 100 is
held in the form of currency and nothing is deposited in the banks,
there is no money for banks to lend out. Then M3 = MB .