Money and Inflation

For Undergraduate Economics Course

Jadavpur University
Dr. Rilina Basu (Banerjee)

1
 The Background
• Barter System
• Problem:
• Double coincidence of wants
• Physical inconvenience

2
 What is Money?
• Money is the set of assets in the
economy that people regularly
use to buy goods and services
from each other
• It is not identical to wealth

3
 Functions of Money
• Medium of exchange
• Unit of Account
• Store of value
• Liquidity

4
 Types of Money
• Commodity Money
Example: gold, silver, copper
• Fiat Money: Money without
intrinsic value
Example: paper money

5
 Forms of money in an
economy
• The total quantity of money
circulating in an economy is called
money stock or stock of money
supply
• The set of assets identified by the
central bank as money is called a
monetary aggregate.

6
 How to measure money ss?
• currency
• Demand deposits
• Other deposits
• Newer forms:
• Plastic card, digital money

7
 Monetary Aggregates
• M1 : Narrow money = currency
held by public i.e. economic
agents outside the banking sector
+ other deposits of RBI + Demand
deposits of banks = C+ D
• M2 : M1 + savings bank deposits
of post offices
• M3 : Broad Money = M1 + time
deposits
• M4 : M3 + deposits of post office

8
 Balance Sheet of RBI
LIABILITIES ASSETS
CURRENCY (i+ii) Domestic Credit (i+ii+iii)
i) Notes in circulation i) Credit to the Govt.
ii) Govt.’s currency liabilities to the ii) Credit to
public comprising rupee coins commercial sector
and smaller coins iii) Claim on banks
Other Deposits (i+ii+iii+iv+v) Net foreign exchange
i)Deposits of quasi govt. & other fin. assets of the central
Institutions bank
ii)Balances in the accounts of other
foreign central banks and govts.
iii) Accounts of international agencies
iv) Provident, Gratuity and guarantee
fund of RBI staff
v) Profit of the RBI held temporarily
under the deposits pending transfer
to the central govt

Banker’s deposits

9
 Balance sheet of Central
Bank
ASSETS LIABILITIES

DC H=C+R

BG

NFA

Basic condition is : Value of asset = value of

liabilities
Supply side determination of high powered
money:
H = DC +BG + NFA
Demand Side Allocation of H : H = C + R
∴ DC +BG + NFA = C + R=H 10
Balance Sheet of Commercial
Banks
ASSETS LIABILITIES

Reserves (R) Deposits (D)

BC : Investment in securities
and bonds
Loans (L)

• L +R = D

11
Monetary Ratio Analysis

• Currency deposit ratio : β

= C/D
• Credit Deposit Ratio: L/D
• Required Reserve Ratio :
α = R/D <1

12
 Money Multiplier
• M=C+D
• H=C+R
C
+1
M C+D β +1
∴ = = D = = m >1
H C+R C R α +β
+
D D
∴M = mH

β +1
M = ( DC + B G + NFA )
α +β
13
 Determinants of Money
Supply
• Those that affect H (i.e. DC, BG, NFA)
• Those that affect m (i.e. α and β)
• Supply of H is assumed to be
exogenous, i.e. given by the authority
• Demand of H is simply the vertical
summation of Cd and Rd

14
• Comparative Statics:
• α⇡
• β⇡
For both these cases Hd shifts leftward
• H⇡
Hs curve shifts upwards 15
Money Multiplier Mechanism
Say H ⇡ by 1 unit ⇒∆H = 1
1st Round: Increase in Ms = 1.
2nd Round: ∆M =∆C + ∆D
Now β = C/D, so β ∆D + ∆D =1
Or ∆D(β +1) = 1 or, ∆ D = 1
1+ β
As deposits increase, given α , credit ⇡
R+L = D or ∆R+ ∆L = ∆D Now, α = R/D
So, ∆R = α ∆D
1−α
α ∆D+ ∆L = ∆D or ∆L = ∆D(1- α)= =x
1+ β
16
• 3rd Round: ∆M = ∆C + ∆D = x (say)
β ∆D + ∆D = x
x
∆D =
1 + β
• Similarly,
1−α 2 1−α 2
∆L = ( )∆D = x = ( )
1+ β 1+ β
• Continuing in this way
1− α 1− α 2
1+ + ( ) + .......... .α
1+ β 1+ β
• 1 1+ β 1+ β
= = = > 1
1− α 1+ β −1+ α α + β
1−
1+ β
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Can money supply be endogenous?

• YES if
1. money multiplier is endogenous
due to excess reserve holding of
banks
And/or
2. NFA changes due to BOP
developments under fixed
exchange rate
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 Balance sheet of
Commercial banks
Asset Liability

Required Reserves (RR) Deposits (D)

Excess Reserves (ER)

Loans (L)

R RR + ER RR ER
Reserve ratio = = = + = α1 + α 2
D D D D
α 2 = f (rd , r , σ )
α1 : required reserve ratio
r: market rate
rd: discount rate
σ : measure of uncertainty or confidence loss
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Modified money multiplier
C +1
M C+D D β +1
= = =
H C+R C +R β + α1 + α2
D D
1+ β
= = m′
β + α1 + f (rd , r,σ )

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Now, as r ⇡ ⇒ α2 ↓ since banks will
no longer hold ER as the
opportunity cost of holding excess
reserves⇡ ⇒ m ⇡ ⇒ M ⇡
So now money supply becomes a
function of interest rate
µ S = µ S ( r ), µ S ′ > 0

Excess reserves, whether desired or

not, do not earn any interest
income to banks. So banks try to
get out of undesired ER and move
into earning assets like loans
21
 TO DO:
• What will happen if rd or σ
changes?

22
 Case of 100% reserve
banking
• All deposits are held as reserves
Asset Liability

R = 100 D= 100

• In this case banks do not influence

money supply

23
Case of fractional reserve
banking
• Fractional reserve: banks hold only a
fraction of all deposits as reserves
• In this case banks influence money
supply
• However, this also makes the banking
system fragile .
• If every depositor wants to withdraw
money at the same time, then there will
be a bank run.

24
Example of fractional reserve system
• Original deposit = 100 (say CRR = 0.1)
• First lending = 90 (0.9 x 100)
• Second lending = 81 (0.9 x 90)
• Third lending = 72.9 (0.9 x 81)
…………………………………..
____________________________
• Total money supply = 100 + 90 + 81 +
72.9 + ………..
= 100 + (100 x 0.9) + (100 x 0.92)+…… α
=100 (1 + 0.9 + 0.9 + ………. α) = 1000 25
• Here, money multiplier is
1/0.1 = 10
• It is the reciprocal of R/D
ratio
• Higher is the Reserve ratio,
lower is the money
multiplier

26
 Monetary Policy
Tools:
1. Open Market operations
2. Lending to banks
• Repo rate and reverse repo rate
• Call money rate
• Bank rate
3. Regulating reserve requirements

27
REPO AND REVERSE REPO RATE
• Repo and Reverse Repo: Repurchase
option is a means of short term
borrowing, where in banks sell
approved government securities to
RBI and get funds in exchange. Repo
rate is the discount rate at which
banks borrow from RBI. So liquidity
moves from RBI to banks . Reverse
repo on the other hand, helps in
absorption of liquidity.
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 CALL MONEY RATE
• Rate of interest on Call Loans (vey
short period loans). This is
strikingly varying and highly
volatile. Depends on CRR
requirements, volume of bank
deposits etc.

29
 Bank Rate
• The rate of interest charged by the
Central bank on the loans they
have extended to commercial
banks and other financial
institutions. There are no
repurchasing agreement signed,
no securities sold or collaterals
involved.

30
 Difference between bank
rate and repo rate
• Bank rate is charged against loans
offered by central bank to commercial
banks, where as repo rate is charged
for repurchasing the securities sold by
the commercial banks to the central
bank
• No collateral is involved while charging
bank rate, but securities, bonds etc are
used as collateral for repo.

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• Repo rate is always lower than bank
rate
• Increase in bank rate directly affects
the lending rates offered to the
customers, there by restricting people
to avail loans where as increase in repo
ate is usually handled by banks and do
not affect customers directly.
• Bank rate caters to comparatively long
term financial requirements of
commercial banks where as repo
focuses on short term financial needs.
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