ME

1. What is a money multiplier? Explain Money Multiplier Approach.

Ans. The money created by the Federal Reserve is the monetary base, also known as high-
powered money. Banks create money by making loans. A bank loans or invests its excess
reserves to earn more interest. A one-dollar increase in the monetary base causes the
money supply to increase by more than one dollar. The increase in the money supply is the
money multiplier.

Money is either currency held by the public or bank deposits: M = C + D

As a starting point for understanding the decomposition of the money supply into the
monetary base and the multiplier, note that the narrow money stock, Ml, is defined as (1)
Ml, = TCD, + C,, where TCD denotes total checkable deposits and C denotes the currency
held by the nonbank public. The monetary base (MB), not adjusted for changes in reserve
requirements, is simply the sum of currency and reserves (including cash in the vaults of
depository institutions) in the banking system, R: (2) MB,= C,+ R,. Currency, supplied by the
Federal Reserve on demand, reflects the portfolio decisions of the public rather than
monetary policy actions. Reserves, in contrast, can be affected directly by the Fed’s sales or
purchases of government securities in the open market. For simplicity, assume that the
Federal Reserve has a simple system of reserve requirements, with required reserves, RR,
given by (3) RR,= rTClJ,, 0 -c r < 1, where r denotes the ratio of reserves that must be held
against TCD.2 A change in the reserve requirement ratio, r, also would constitute a
monetary policy action by the Fed.

2. Difference between Bank Rate and Repo Rate.

Ans.

Bank Rate Repo Rate

The markdown rate at which the National Bank
The repo rate is a fee that the national bank lends to a
loans credit to business banks and monetary
commercial bank for a short period.
organisations is known as the Bank Rate.
There is no such thing as a repurchase Repo Rate refers to selling assets to the central bank
agreement under a bank rate; instead, money is under a repurchase agreement. Securities to the future
lent to banks and financial intermediaries at a predator with the significant bank aggression closed the
fixed rate. rate and date.
The apex bank charges the bank rate on loans it The interest rate imposed on the buyback of securities, as
extends to the commercial bank. opposed to the Repo Rate.
The bank rate is used to move commercial banks The repo rate is applied to repurchase of assets sold by
forward with the Central Bank. commercial banks to the Central Bank.
When charging a Bank Rate, no insurance is When setting Repo Rate, protections, security,
offered. arrangements, and guarantees are included.
Bank Rate caters to business banks' long-term
Repo Rate caters to their short-term needs.
monetary needs.
3. What are the factors that influence the demand for money?
Ans. The demand for money gets affected by several factors, such as the interest rate, the
level of income, inflation and uncertainties in the future.
How these factors affect the demand for money is explained by three motives which
demonstrate the need for cash.
The transaction motive explains that the demand for money is essential for the transaction,
which involves the exchange of money. It is crucial to have cash for transaction purposes.
The precautionary motive implies the money is demanded the precaution purposes, that is,
the uncertainty in the future. There can be any unexpected expenses which will require
immediate payments, like medical bills.
The third is the speculative motive which treats money as a store of value, an asset. The
demand for this asset will depend on the rate of return and the opportunity cost. The
money holding generally provides no rate of return but depreciates due to the rise in prices.
The opportunity to hold money is the interest that will be foregone if the money holding
was invested elsewhere.
Therefore, the speculative demand for money will arise when holding money is considered
less risky than the other alternatives of lending or investing it in other assets.