15-11-2023

WHAT IS MONEY?

MONEY:  Essential part of an economy because of its usefulness

DEMAND AND SUPPLY
Medium of exchange

Store of value

SESSIONS 6, 7 & 8 Unit of account

 A medium of exchange must necessarily be a store of

1
value but stores of value are not necessarily money.

 Distinction? Its liquidity 2

CHARACTERISTICS OF MONEY INTEREST RATE

 What is the difference between real and nominal interest

 Convenient to carry
rate?

 Made from durable material  Which one is observable?

 Which one is more useful for economic decisions?

 No intrinsic value but backed by legal authority, usually the  Can interest rate be negative?
monetary authority of a sovereign state.

 Legal tender – fiat money 3 4

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US: REAL AND NOMINAL INTEREST RATES (THREE-MONTH TREASURY

BILL), 1953–2002 FINANCIAL ASSETS

 Money is a financial asset, but it does not earn any interest or

return if we hold on to it (return is negative with inflation).

 There are a large number of financial assets that earn interest or

some rate of return, like a bank deposit or a government bond.

5 6

FINANCIAL ASSETS REAL AND NOMINAL RATE

 Suppose you have a fixed deposit Rs. 100 for 1 year last year, and it
 Real rate of interest: r [is adjusted for inflation]
earns interest of Rs. 10 after 1 year. The return appears to be 10%
 Nominal rate of interest: i [is not adjusted for
 But suppose prices have increased by 10%. inflation]

 Rate of inflation expected: Eπ

 Then the Rs. 100 last year has exactly the same purchasing power of
Rs. 110 this year.  It is easy to see that i = r + Eπ

 What “real” return did you have?

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EXPECTED INFLATION AND INTEREST RATES (THREE-

MONTH TREASURY BILLS), 1953–2002, US
A SPECIAL FINANCIAL ASSET
 Consider a perpetuity: a tradable government bond that
promises an annual rate of return say 5% and lives forever.
 If the face value is Rs. 100, then initially you buy it at Rs.100
and then whoever holds it at the end of the year gets Rs. 5.
 Trading can take place at any price
 If the market price Pb is above Rs. 100 then the annualized
interest is less than 5%. Similarly, the opposite holds.

 The price of the bond is negatively related to the

9 market interest rate. 10

BOND MARKET: PRICE & SPOT RATE DEMAND FOR MONEY

Bond Price
 Three theories:

 Quantity theory

 Liquidity preference theory

 Baumol-Tobin model

Spot rate 11 12
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THE DEMAND FOR MONEY THE QUANTITY THEORY OF MONEY

 Three important empirical observations about money demand:
 All other things equal, the demand for nominal money is
negatively related to the nominal interest rate on bonds, because
this nominal interest rate is the “opportunity cost” of holding
money.
 All other things equal, the demand for nominal money is greater
when income is higher and lower when income is lower. Money
is needed to carry out transactions, which vary in proportion to
income.
 All other things equal, the demand for nominal money is higher
when the general price level is higher and lower when the general
price level is lower. More rupees are needed to pay for goods
when the general price level goes up. 13
 The quantity theory involves price and income, but not the
interest rate
 Demand for money, M is proportional to nominal GDP, PY
 The theory postulates that if the demand for money is different
from what is supplied, it is the price level that adjusts to make
demand = supply
 It is the ‘quantity’ of money that determines the ‘price level’ in
the economy
 The theory is applicable in the long run, or, when the price level
is fully flexible 14

THE QUANTITY THEORY OF MONEY THE QUANTITY THEORY OF MONEY

 In the long run, the real GDP, Y is given (at full

M = kPY
capacity level)
M (1/k) = PY ; PY is nominal income
 So, any increase in money supply will show up as
 MV = PY : V is 1/k called income velocity of
an increase in the price level
circulation, how many times a rupee enters a
 Note: Money demand does not depend on interest
person’s income in a given period of time.
rate in quantity theory
V is taken to be constant.
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MONEY SUPPLY AND PRICE LEVEL IN THE GERMAN

INFLATION IN QUANTITY THEORY HYPERINFLATION

 Inflation is a continuous rise in the price level

 MV = PY implies that if all resources are fully utilized

(i.e., Y maximum possible) a rise in M leads (with const
V) to a proportionate rise in P (inflation).

 gM + gV = gP + gY

 Very high inflation are often a result of rapid increases in

money supply.

 Quantity theory is a good predictor of hyperinflation. 17 18

KEYNES : THE LIQUIDITY PREFERENCE THEORY KEYNES : THE LIQUIDITY PREFERENCE THEORY

 In “General Theory” Keynes distinguished between three motives  Keynes argued that since prices did not adjust in the short run,
for holding money the interest rate adjusted to set demand for money equal to the
supply set by the monetary authorities (the Central Bank).

 Transactions-motive arising due to the need for cash which

supports circulation of the current level of output  The speculative demand for money and expected interest rate.

 Precautionary-motive arising out of uncertainty about the gap

between payment and receipt and  How would prices, expected prices and expected interest rates
affect the current demand for money?
 Speculative-motive due to anticipation of increase in the value of
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current wealth
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L P THEORY: EXPECTATION & MONEY DEMAND THE WEALTH CONSTRAINT

Interest rate  (M/P)d + (B/P)d = (M/P)s + (B/P)s = Financial Wealth

 (M/P)d − (M/P)s = (B/P)s − (B/P)d

 Note: If the money market is in equilibrium, then the bond

i0 market has to be in equilibrium.
 Excess demand for money is equal to the excess supply of bonds.
 The money market and the bond market are mirror images of one
another.
 We need to consider only one of the two markets and analyze the
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M0 Amount of M equilibrium, the other equilibrium is ensured

KEYNES: THE DEMAND FOR MONEY DETERMINATION OF INTEREST RATE: LP THEORY

 The demand for real balances:

How the dependence on income Y
r
 (M/P)d = L (i, Y ) ≡ k Y + L(i) (M/P)d = L (r,Y ) is captured in the Money demand
schedule?
(−, +)
The schedule is drawn for a
given level of income Y
 The supply is determined by the monetary authority r*

(central bank), in India it is the Reserve Bank of India

Real Money Demand
 Can we write real interest rate instead of nominal
interest rate in the demand function? Money Supply, Demand
MS/P

 Yes, when prices are sticky and hence π =0 23 What happens to the eqbm interest rate when either demand for or 24
supply of money goes up?
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MONEY SUPPLY: MEASURING THE MONEY STOCK THE MEASURES OF RBI

 M1: CU + D
 Measuring money is always somewhat arbitrary to (Currency with non-bank public + demand deposits at
commercial banks net of inter-bank deposits)
the extent what should be included as money and
what should not be.  M2: M1 + Deposits at PO

 M3: M1 + Net time deposits of banks

 Measures vary (marginally from country to country)  M4: M3 + Deposits at PO

 M1  Narrow money
 We will look at the money stock measures of RBI in  M3  Broad money (in India it is also called “AMR”

25 aggregate monetary resources) 26

India

THE BANKING SYSTEM RBI’S CONSOLIDATED B/S

 The process of credit creation  LIABILITIES  ASSETS

 The cash reserve ratio (fractional reserve system) 1. Currency 3. Net forex assets
2. Deposit of Banks 4. Net RBI credit to
 Banking habits and transactions technology 3. Deposit of GoI government
5. Credit to commercial
sector
 Demand for credit and banks being fully loaned
up
Liabilities of the RBI are called Base Money/Reserve
 The money multiplier 27 Money/Monetary Base/High Powered Money 28
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BANKING SYSTEM’S CONSOLIDATED B/S  The monetary base is the sum of currency in circulation and bank
reserves.
 Money supply is the sum of currency in circulation and Bank deposits
 LIABILITIES  ASSETS
 The money multiplier is the ratio of the money supply to the monetary
base.
1. Deposits (Demand + 2. Cash reserves (cash in
Time) hand + reserves with RBI)
3. Net bank credit to
government
4. Commercial credit

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DERIVING THE MONEY MULTIPLIER DERIVING THE MONEY MULTIPLIER

 Concentrate on M1 only
B = CU + R = β D + α D = (α + β)D
 Base money B = CU + R (currency + reserves)
 By asset-liability equality of the RBI, B = FA + DC (foreign  So, D = [1/ (α + β)] B
asset + domestic credit)
 M1 = MS = CU + D = β D + D = (β +1)D
 Hence, B = CU + R = FA + DC
 Do we put all our monetary savings in the form of deposits?  i.e. MS = [(β + 1)/ (α + β)] B
 Some fraction is held in cash
 The money multiplier = (β + 1)/ (α + β)
 Desired currency holding CU = β D; 0 < β < 1
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 Let CRR = α, so that R = α D
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PROPERTIES OF MONEY MULTIPLIER INDIA - MONETARY AGGREGATES

 Is it > 1 or < 1?

 Both α & β lie between 0 and 1

 So money multiplier > 1

 The multiplier will change if α, β and B change

 The relation between MS and B hold only when banks

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are fully loaned up
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MONEY MULTIPLIER AND BEHAVIOURAL RATIOS TRADITIONAL INSTRUMENTS OF MONETARY POLICY

TO INFLUENCE MONEY SUPPLY AND INTEREST RATE

 Cash Reserve Ratio (bank reserve ratio):

 The minimum cash reserves required to be maintained by commercial
banks

 Bank Rate: The rate which RBI charges for loans to

banks
 Open Market Operations (OMO): Purchase and sale of
government securities
 Outright
 Repo/Reverse Repo
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MONETARY POLICY INSTRUMENTS IN INDIA DIFFERENT INTEREST RATES IN INDIA (11/10/2023)

 Repo Rate: 6.5 %

 Direct
 Reserve requirements as % of NDTL (Net Demand & Time  Reverse Repo Rate (fixed): 3.35%
Liabilities)  MSF Rate: 6.75 %
 CRR - cash or deposits with RBI
 Statutory liquidity ratio (SLR) – liquid assets such as government
 Bank Rate: 6.75 %
securities
 CRR: 4.5 %
 Selective Credit control
 Administered interest rates
 SLR: 18 %
 Base Rate: 8.85 – 10.10 %
 Indirect:  Savings Bank Rate: 2.7 – 3%
 Repurchase (repos) and outright transactions in securities  Term Deposit Rate (> 1 year): 6.00 – 7.25 %
(open market operations)
 Direct lending, refinance, rediscounting  Money Market Call Rate: 4.1 – 5.95%
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