MODULE 3

WHAT IS MONEY?
“Money is whatever is generally accepted in exchange for goods and services—accepted not
as an object to be consumed but as an object that represents a temporary abode of
purchasing power to be used for buying still other goods and services.” Milton Friedman
What is Money
◼ Money is a system of value that facilitates the exchange of goods in an economy. Using
money allows buyers and sellers to pay less in transaction costs, compared to barter trading
◼ Money is any item or medium of exchange that is accepted by people for the payment of
goods and services, as well as the repayment of loans.
◼ Money makes the world go 'round.
◼ Economies rely on money to facilitate transactions and to power financial growth.
Typically, it is economists who define money, where it comes from, and what it's worth. .
Properties of Money
◼ Money Should Be Fungible
❑ The word fungible refers to a quality that allows one thing to be exchanged, substituted,
or returned for another thing, under the assumption of equivalent value. Thus, units of
money should be interchangeable with one another.
❑ For example, metal coins should have a standard weight and purity. Commodity money
should be relatively uniform in quality. Trying to use a non-fungible good as money results in
transaction costs that involve individually evaluating each unit of the good before an
exchange can take place.
◼ Money Should Be Durable
❑ Money should be durable enough to retain its usefulness for many, future exchanges. A
perishable good or a good that degrades quickly due to various exchanges will be less useful
for future transactions. Trying to use a non durable good as money conflicts with money's
essential future-oriented use and value.
◼ Money Should Be Portable
❑ Money should be easy to carry and divide so that a worthwhile quantity can be carried on
one's person or transported. For example, trying to use a good that's difficult or
inconvenient to carry as money could require physical transportation that results in
transaction costs.
◼ Money Should Be Recognizable
❑ The authenticity and quantity of the good should be readily apparent to users so that
they can easily agree to the terms of an exchange. Using a non-recognizable good as money
can result in transaction costs relating to authenticating the goods and agreeing
on the quantity needed for an exchange.
◼ Money's Supply Should Be Stable
❑ The supply of the item used as money should be relatively constant over time to prevent
fluctuations in value. Using a non-stable good as money produces transaction costs due
to the risk that its value might rise or fall, because of scarcity or over abundance, before the
next transaction.
PRIMARY FUNCTIONS OF MONEY
1. Medium of Exchange: Money act as a medium of exchange. It has the quality of general
acceptability. In modern days, exchange is the basis of entire economy and money makes
this exchange possible. It was on account of the difficulties and inconveniences (lack of
double coincidence of wants) of Barter system the money came into existence.
2. Measure of Value: Money act a unit of measure of value. In other words, it acts as a
yardstick of standard measure of value to which all other things can be measured. Value of
all goods and services is expressed in terms of money.
SECONDARY FUNCTION OF MONEY
3. Standard of Deferred Payments : Money has proved to be a suitable standard of deferred
payment as it is more durable and stable compared to values of other commodities . It has
the quality of general acceptability. Hence it is always desirable.
4. Store of Value : Money can be stored for future use. It has this merit because its utility is
never lost. It serves as an excellent store of wealth, as it can be easily converted into other
marketable assets , such as land, machinery , plant etc.
5. Transfer of Value : Money is a liquid means of exchange. Hence purchasing power of
money can easily be transfered from one person to another and from one place to another.
TYPES OF MONEY
◼ Commodity Money
• It is the easiest, most likely, and the oldest type of money. It builds on scarce natural
resources that work as a source of exchange, storage value, and unit of account.
• Commodity money is closely related to (and originates from) a barter system, in which
goods and services are directly interchanged for other goods and/ or services.
• Commodity money is a way of simplifying the process, as it acts as a commonly accepted
medium of exchange.
• The significant thing about commodity money is that its value is described by the actual
value of the commodity itself.
• Few examples of money are gold coins, shells, spices, beads, etc.
◼ Fiat Money
• Fiat money is a type of paper money. It is the money which has a face value more than its
real value.
• The actual value of money is worthless. It is accepted by the people on the order of the
government.
• The face value is decided by the government and the money is not exchanged into
standard money.
• The fiat money is used as a medium of exchange and as a standard of value. It may be
paper money or any kind of commodity.
• This type of money is issued across the world.
◼ Metallic Money
• Pieces of metals like gold, silver, bronze, and copper came to be used as money in both
ancient as well as current times. It can be classified as
metallic money.
• The value of these in exchange of goods is equivalent to their actual/ intrinsic value.
• Metallic money can be categorized into full bodied coins and token coins.
◼ Paper Money
• Paper money refers to the bank notes and government notes which are used as money.
• The distribution of the paper money started in order to replace the metallic money.
• In the modern days, paper notes inherited the characteristics of token money, being
commonly acceptable without reference to that of the
metallic equivalent
◼ Fiduciary Money
• It is known for its value on the confidence that it will be commonly considered as a mode
of exchange.
• Like fiat money, the fiduciary money is not considered a legal tender by the government.
• In case asked by the bearer, the issuer of the fiduciary money guarantees to exchange it
back for a commodity or fiat money.
• As long as the parties involved are confident that the assurance will not be broken, they
may use the fiduciary money just like the regular fiat or commodity money.
• Examples of fiduciary money are demand drafts, cheques.
◼ Commercial Bank Money
• It can be regarded as claims against the financial entities, which may be utilized to buy
goods and/ or services.
• The commercial bank money is created through so-called fractional reserve banking
• Fractional reserve banking is when the commercial banks provide loans and/ or advances
worth greater than the value of the real currency they possess.
◼ Representative Money
• All token coins and paper notes that can be readily converted into fullbodied coins or
equivalent bullion (gold, silver, etc.) at a fixed rate, are known as representative money.
• Such a kind of money was accepted in India in 1927 when rupee notes and coins were
easily able to convert into gold.
SOURCES OF MONEY SUPPLY
◼ Central Bank is the main source of Money Supply
◼ Money supplied by Central Bank is High Power Money
◼ Second major source of money supply is banking system in the country
◼ Bank create Money Supply in the process of borrowing and lending money to the
publiccalled as credit money
CENTRAL BANK AND HIGH
POWERED MONEY SUPPLY
◼ Central Bank of all countries are empowered to issue the currency called as High Powered
Money because it is generally backed by supporting reserves and its value is guaranteed by
the government and it is the source of all other forms of money
◼ The currency issued by the Central Bank is in fact a liability to the Central Bank and the
govt. therefore, this liability must be backed by some
value of assets consisting mainly of gold and foreign exchange reserves. Minimum Reserve
System
CENTRAL BANK AND HIGH
POWERED MONEY SUPPLY
◼ Under Minimum Reserve System, the
Central Bank is required to keep a
reserve certain minimum reserve of gold and foreign securities and is empowered to issue
currency to any extent
◼ Presently, India follows the reserve of
only gold of Rs 200 crore, makes only 1%reserve MEASURE OF HIGH POWERED MONEY
SUPPLY IN INDIA H = C + R + OD Where C= currency held in public, R= cash reserves of
commercial banks, OD= other deposit with the RBI (constitute only 1% in India)
◼ The R with the commercial banks forms the basis of Money Supply by the banks. The
money (credit) supplied by the banks increases Money Supply in circulation in addition to H
MONEY SUPPLY IN INDIA
◼ In the context of RBI measures of Money Supply, the following definitions must be borne
in mind
❑ Money Supply is a stock variable and measure of Money Supply refers to the stock of
money at a point of time
❑ Measure of Money Supply is meant the measure of stock of money available to the public
as a means of payment and store of value
❑ The term public means all economic units including households, firms and institutions RBI
MEASURE OF MONEY SUPPLY M1 = C + DD + OD M2 = M1 + Saving deposit with post offices
M3 = M1 + Net time deposits with Commercial banks M4= M3 + Total deposits with post
offices (including NSC)Where C= currency held by public, DD= net demand deposits by
banks, OD = Other deposits with RBI and NSC = National Saving certificates
COMMERCIAL BANK AND
MONEY CREATION
◼ Credit Money that bank creates is an outcome of their business transactions, mainly
borrowing and lending
◼ Banks receive deposits from the public called primary deposit (depend on Hh savings
deposited with banks, payment received from the central bank for sale of govt bonds,
payment received from abroad and deposited with bank and money deposited for
convenience in transaction)
◼ On the basis of Primary Deposit, Bank
creates secondary deposits. It is the volume of derivative deposits which constitutes the
Money Supply by the Banks
◼ It begins with bank lending money out of
primary deposits
◼ The amount of total derivative deposits
created by the banks depend on
❑ The amount of primary deposits
❑ The rate of required reserves
❑ Demand for bank loans by the society
❑ Efficiency of the Banking system
DEPOSIT CREATION BY THE
BANK
◼ Assumptions
❑ There is a single bank
❑ Bank accepts only demand deposits
❑ CRR is 20%
❑ Bank holds its assets only in the form of cash
reserve and loans and advances
◼ Process of Credit creation or deposit creation
BALANCE SHEET(from pdf)
DEPOSIT MULTIPLIER
DM = ∆D = 500 = 5
∆R 100
Where ∆D is the additional deposits created by
the Banks (including the initial deposits) and ∆R
is change in cash reserves of the Banks ∆R is equal to primary deposit ∆D can be computed
in several ways
◼ ∆D = 100 + 80 + 64……+0 = 500
DM = ∆D = 1 = 1 = 5
∆R r 0.2
CENTRAL BANK FUNCTIONS
◼ A central bank has been described as the "lender of last resort," which means it is
responsible for providing its nation's economy
with funds when commercial banks cannot cover a supply shortage. In other words, the
central bank prevents the country's banking system from failing.
◼ However, the primary goal of central banks is to provide their countries' currencies with
price stability by controlling inflation. A central bank also acts as the regulatory authority of
a
country's monetary policy and is the sole provider and printer of notes and coins in
circulation.
CENTRAL BANK FUNCTIONS
◼ Time has proved that the central bank can best
function in these capacities by remaining
independent from government fiscal policy and
therefore uninfluenced by the political concerns
of any regime. A central bank should also be
completely divested of any commercial banking
interests.
• Central banks carry out a nation's monetary policy and control its money supply, often
mandated with maintaining low inflation and steady GDP growth.
• On a macro basis, central banks influence interest rates and participate in open market
operations to control the cost of borrowing and lending throughout an economy.
• Central banks also operate on a micro-scale, setting the commercial banks' reserve ratio
and acting as lenders of last resort when necessary.
CENTRAL BANK IN INDIA
◼ In India, the Reserve Bank of India is
regarded as the central bank. It was set
up in 1935. Central banks are responsible for maintaining the financial stability and
economic sovereignty of the country.
MAIN FUNCTIONS OF CENTRAL BANK
◼ 1. Currency regulator or bank of issue
◼ 2. Bank to the government
◼ 3. Custodian of Cash reserves
◼ 4. Custodian of International currency
◼ 5. Lender of last resort
◼ 6. Clearing house for transfer and
settlement
◼ 7. Controller of credit
◼ 8. Protecting depositors interests
COMMERCIAL BANKS
◼ A commercial bank is a financial institution
that provides services like loans, certificates of
deposits, savings bank accounts bank overdrafts, etc. to its customers.
◼ These institutions make money by lending
loans to individuals and earning interest on
loans.
◼ Various types of loans given by a commercial
bank are business loans, car loans, house
loans, personal loans, and education loans.
INFLATION
Concept, Indices and Determinants
WHAT IS INFLATION
◼ A continuous & persistent increase in the general price level
◼ Measures average change in absolute prices
◼ Price is nothing but the exchange value of a unit of a commodity or service expressed in
terms of money
◼ Value of money in an inflationary period
Real Value of Rs. 1 = Rs. 1 / Price Level
How to measure Inflation
n
Pt = Σ Wi Pit (i= 1 to n)
i=1
Pt = general price in period t
Pit = Price of good i in period t
Wi= weight of good i
Wi > 0
ΣWi = 1
MEASURING INFLATIONTHE GENERAL PRICE(from pdf)
0.55 (40) + 0.30 (100) + 0.15 (1000) = 202 Goods Price (Rs.) Unit Weight Apple 40 Kg 0.55
Trouser 100 Piece 0.30 Room 1000 Month 0.15
Class Exercise(from pdf)
How to get W
W is the relative significance of the good in the basket of the commodities during the base
period
Wi = Qio Pio/ Σ Qio Pio The price index expresses the current price in relation to its value in
the base period. Thus, Price index for period t is
 Pit = Pt/Po For general price (weighted average of various prices), the price index (Pit) is Pit
= Σ Wi[Pit/Pio]
LASPEYRE’S INDEX
Substituting for Wi, we get
Σ Qio Pit/Σ Qio Pio This is known as Laspeyre’s Index (weighted aggregate price index where
the weights are determined by quantities in the base year)
PAASCHE’S INDEX
◼ Paasche’s Index (weighted aggregate price
index in which the weights are determined by
quantities in the given year) Σ Qit Pit/Σ Qit Pio
◼ Difference between L and P is former works
with base year quantities and latter works
with end year quantities as weights Price rise but not inflationary
◼ Price rise on account of the following factors
is not inflationary
❑ Price rise due to change in the composition of
GDP. Ex. High price industrial goods replace low
price farm products
❑ Price rise due to qualitative change in the
products across the board
❑ Price rise due to change in price indexing system
❑ Recovery of price after recession
HOW INDIA MEASURES INFLATION
◼ India uses the Wholesale Price Index (WPI)
to calculate and then decide the inflation rate
in the economy.
◼ Most developed countries use the Consumer
Price Index (CPI) to calculate inflation
WPI as measure of Inflation in India
◼In India, a total of 435 commodities data on
price level is tracked through WPI which is an
indicator of movement in prices of commodities
in all trade and transactions.
◼ It is also the price index which is available on a
weekly basis with the shortest possible time lag
as compared to other indices
◼ Helps us gauge the source of inflation, unlike
other measures
CPI IN INDIA
◼ It is a statistical time-series measure of a
weighted average of prices of a specified set of
goods and services purchased by consumers.
◼ It is a price index that tracks the prices of a
specified basket of consumer goods and services.
◼ CPI is a fixed quantity price index and
considered by some a cost of living index.
Terms Related With Inflation
◼ Hyper or Galloping Inflation
◼ Deflation
◼ Disinflation
◼ Stagflation
TYPES OF INFLATION
◼ Demand-pull Inflation: Caused by increases in aggregate demand outpacing increases in
aggregate supply.
◼ Cost-push Inflation: Caused by increases in production costs cause firms to raise prices.
◼ Built-in or Hangover Inflation:
❑ Expectations
❑ Price-Wage Spiral Aggregate demand, aggregate supply and the price level Causes of
Inflation: Demand-pull Inflation
◼ Too Much money chasing too few
goods
◼ That is where supply cannot increase
because the economy is operating at full
capacity—all resources are being used
◼ The excess demand will bid up the prices
of the output The Inflationary Gap
◼ The excess demand that cannot be satisfied
when the economy is operating at full capacity
◼ How the government can close the gap
• Reduce government spending
• Increase personal income tax
• Increase interest rates
• Reduce tariffs on imported goods
Demand-pull inflation
Demand-pull inflation

Price-wage Spiral
◼ Wages chase prices and prices chase wages
◼ Wages: Taxable salary or nominal salary
should move faster than the cost of living in
order to maintain the purchasing power
◼ Increase in wages results in hike in the cost
of production
◼ Business owners raise prices to protect profit
margins from rising costs…
REDISTRIBUTIVE EFFECTS OF INFLATION
◼ Real income measures the amount of goods
and services your money income can buy.
Change in real income = Change in nominal
income – Change in price level
◼ Adverse redistributive effects of inflation on:
❑ Fixed-nominal-income receivers (e.g. fixed
pension)
❑ Redistribution benefit from Creditors (lender) to Debtors (borrower)
❑ Savers (when rate of inflation > interest rates)
Effects of Inflation for financial capital
◼ Unanticipated inflation has two main
consequences in the market for financial
capital: it redistributes income and results in
too much or too little lending and borrowing.
❑ If the inflation rate is unexpectedly high, borrowers gain but lenders lose.
❑ If the inflation rate is unexpectedly low, lenders
gain but borrowers lose.
EFFECTS OF INFLATION
◼ Inflation is a problem when income rises at a
slower pace than prices
◼ Shoe-Leather Cost: When inflation occurs,
nominal interest rate (=real interest rate +
expected inflation) goes up, which induces
people to hold less real cash balance- more
bank trips (it tends to increase investment and
demand for durable goods)
◼ Money Illusion Cost: Purchasing power &
Consumption spending
◼ Bracket Creep: Progressive tax
Measures to Control Inflation
◼ Control Money Supply (↓ MS, ↓D,↓ P)
◼ Interest Rate (↑IR, ↓ MS)
◼ Increase taxation (↓ DI, ↓D, ↓P)
◼ Decrease government spending (↓E, ↓D, ↓P)
◼ Public Borrowing (↓ MS)
◼ Wage and Price Controls- Stabilize changes
◼ Increase supply of goods and services
Positive Effects of Inflation
◼ Room to Maneuver
❑ A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently
above zero so that if the need arises the bank can cut the nominal interest rate.
◼ Tobin Effect
Moderate level of inflation → Investment → Faster growth.
◼ Inflation lowers the return on monetary assets relative to real assets, such as physical
capital.
◼ To avoid inflation, investors would switch from holding their assets as money to investing
in real capital projects increase in costs.
Quantity theory of money
◼ According to the quantity theory of money, the general price level of goods and services is
proportional to the money supply in an economy. While this theory was originally
formulated by Polish mathematician Nicolaus Copernicus in 1517, it was popularized later by
economists Milton Friedman and Anna Schwartz after the publication of their book, "A
Monetary History of the United States, 1867-1960," in 1963.
◼ According to the quantity theory of money, if the amount of money in an economy
doubles, all else equal, price levels will also double. This means that the consumer will pay
twice as much for the same amount of goods and services. This increase in price levels will
eventually result in a
rising inflation level; inflation is a measure of the rate of rising prices of goods and services in
an economy.
QUANTITY THEORY OF MONEY
◼ The same forces that influence the supply and demand of any commodity also influence
the supply and demand of money: an increase in the supply of money decreases the
marginal value of money–in other words, when the money supply increases, but with all else
being equal or ceteris paribus, the buying capacity of one unit of currency decreases.
◼ As a way of adjusting for this decrease in money's marginal value, the prices of goods and
services rises; this results in a higher inflation level.
◼ Fisher's Equation of Exchange is an identity that always holds true by definition. It
essentially states that the quantity of money spent in an economy needs to equal the
quantity of money used. This is expressed as
◼ MV= PT
◼ M = Quantity of money
V = Money velocity of all transactions (money turnover)
P = Price level of all transactions
T = Total transactions in the economy.
◼ According to the QTM, in any given time period, total money expenditure is equal to the
total value of goods traded in the economy. The volume of transactions T depends on the
supply of goods and services to be exchanged. The greater the supply of goods in an
economy, the larger the number of transactions and trade, and vice versa.
◼ In this equation, as with the price of a commodity, the value of money is determined by
supply and demand factors.
◼ Under the assumption of full employment and full use of all resources, Y cannot be
increased and is therefore assumed constant.
◼ Another central assumption is that the velocity of money V is considered fixed or
externally determined. With V and Y being held constant, the QTM then states that prices P
evolve
proportionally to the money supply M.
◼ MV=PY ⟺P=V M/Y
◼ That is, any change in M leads directly to a
change in P, or in other words, an increase in the
money supply causes inflation.
◼ It's worth noting that M itself can be broken up
into at least two components. Monetary assets
that are very liquid, such as cash, are considered
part of "M1". Other monetary assets including
savings deposits are part of "M2".
MONEY MARKET
◼ In India, money markets serve an essential objective of providing liquid cash to borrowers
and fund providers for a small period of time, while keeping a balance between the supply
and demand short-term funds
◼ A random course of financial institutions, bill brokers, money dealers, banks, etc., wherein
dealing on short-term financial tools are being settled is referred to as Money Market. These
markets are also called wholesale markets.
◼ Money Market is a disorganised market, so the dealing is done off the public exchange
market, i.e. Over The Counter (OTC), within two bodies by
using email, fax, online and phones, etc. It supports the industries to accomplish their
working capital demand by circulating short-term
funds in the economy.
FEATURES OF MONEY MARKET
• It is fund-term market funds.
• It’s maturity period up to one year.
• It trades with assets that can be transformed into cash easily.
• All the transactions take place through phone, email, text, etc.
• Broker not required for the transaction
• The components of a money market are the
Commercial Banks, Non-banking financial companies and Central Bank, etc.
CAPITAL MARKET
◼ A kind of financial market where the company
or government securities are generated and
patronised with the intention of establishing
long-term finance to coincide the capital
necessary is called Capital Market.
◼ In this market, the buyers use funds for longerterm investment. The nature of the capital
market is risky markets. Therefore, it is not
used for short-term funds investment. Most of
the investors obtain the capital markets to
preserve for education or retirement.
FEATURES OF CAPITAL MARKET
• Unites entrepreneurial borrowers and
savers
• Deals with long-term investments.
• Agents are required.
• It is controlled by government rules and
regulations.
• Deals in both commercial and noncommercial securities.
• Foreign Investors.
MONETARY POLICY
Monetary Policy is essentially a 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 predetermined macroeconomic
goals
◼ In a full monetized economy, scope of
Monetary Policy encompasses the entire economic activities (production, consumption,
savings, investment and foreign trade).
◼ Monetary Policy works by changing the supply of and demand for money and the general
price level.
◼ Monetary Policy influence all major
macroeconomic variables- GDP, savings,
investment, employment, general price level, foreign trade and BOP Monetary Policy
◼ Effectiveness and scope of Monetary Policy is also depend on how developed and
integrated is the capital market (CM).
◼ Some instruments work through the capital market (Bank rate, CRR). Where capital
market is fairly developed, MP affects the level of economic activities through changes in
CM.
◼ Developed CM:
❑ large number of financially strong commercial banks/ financial Institutions/ credit
organizations /short-term bill markets,
❑ major part of financial transactions are routed through CM,
❑ working of capital sub-markets are inter-linked and
❑ interdependent and commodity sector is highly sensitive to the changes in the capital
market.
OBJECTIVES OF MONETARY POLICY
◼ The primary objectives of monetary policies are the management of inflation or
unemployment and maintenance of currency exchange rates.
◼ Inflation
❑ Monetary policies can target inflation levels. A low level of inflation is considered to be
healthy for the economy. If inflation is high, a contractionary policy can address this issue.
◼ Unemployment
❑ Monetary policies can influence the level of unemployment in the economy. For example,
an expansionary monetary policy generally
decreases unemployment because the higher money supply stimulates business activities
that lead to the expansion of the job market.
◼ Currency exchange rates
❑ Using its fiscal authority, a central bank can regulate the exchange rates between
domestic and foreign currencies. For example, the
central bank may increase the money supply by issuing more currency. In such a case, the
domestic currency becomes cheaper relative to its foreign counterparts.
Instruments of MP
◼ Quantitative
❑ Open Market Operations (OMO)
❑ Discount Rate or Bank Rate (BR)
❑ Cash Reserve Ratio (CRR)
◼ Qualitative
❑ Credit Rationing
❑ Change in Lending margins
❑ Moral Suasion
❑ Direct Controls
OPEN MARKET OPERATIONS (OMO)
◼ Sale and purchase of government securities
and treasury bills by the Central Bank. When
CB decides to pump money into circulation, it
buys back the government securities, bills
and bonds and vice versa
◼ CB carries out its OMO through the
commercial banks- it does not deal directly
with public. The buyers include commercial
banks, financial corporations, business
corporations and individuals with high
savings. These customers hold their
accounts with the banks
OPEN MARKET OPERATIONS (OMO)
◼ Therefore, when the CB carries out its OMO,
it affects bank deposits and reserves, and
thereby, their capacity to create credit.
◼ Sale of bond reduce supply of credit
❑ If people buy, they transfer money from
commercial bank to CB
❑ When commercial bank buys, this results in
reduction in cash reserves
OMO is ineffective when
◼ Commercial Bank possess excess liquidity
◼ When banking system is not well developed
◼ Popularity of government bonds and
securities
DISCOUNT RATE OF BANK RATE (BR)
◼ BR is the rate at which CB rediscounts the bills
of exchange presented by the commercial
banks. BR is the rate which CB charges on the
loans and advances to the commercial banks.
◼ When commercial banks are faced with
shortage of cash reserves, they approach the
CB to get their bills of exchange rediscounted. It
is a general method of borrowing by the
commercial bank. The CB rediscounts the bills
presented by the commercial bank. This rate is
bank rate.
◼ CB can change this rate- increase or
decrease- depending on whether it wants to
expand or reduce the flow of credit from the
commercial bank
❑ When to increase credit creation, it reduces BR
and vice versa
◼ BR affects the flow of bank credit in three
ways
❑ Reduces commercial bank capacity to borrow and low cash reserves with them
❑ When BR increase, commercial bank also raise their rate of interest which raise cost of
bank credit
❑ Banker’s lending rate is quickly adjusted to deposit rates. Rise in BR increases the deposit
rate and hence saving flow into the banks in the forms of deposits and money with public
decreases- Deposit Mobilization Effect Limitations of BR
◼ Effective only if commercial bank has to
borrow only from CB
◼ Effective only if demand for credit is interestelastic Cash Reserve Ratio or Statutory
Reserve Ratio
◼ CRR is the % of total deposits which
commercial banks are required to maintain in
the form of cash reserve with the CB
◼ Contractionary MP= raises CRR (Reduces
MS)
◼ Expansionary MP= reduce CRR (Increases
MS)
CASH RESERVE RATIO OR STATUTORY RESERVE RATIO
◼ SLR
❑ In India, RBI has imposed another reserve
requirement
❑ It is a proportion of the total deposits, which
commercial banks are statutorily required to maintain in the form of liquid assets (cash
reserves, gold and government bonds) in addition to CRR
❑ To prevent the commercial banks from liquidating their liquid assets when CRR is raised
QUALITATIVE MEASURES
◼ CREDIT RATIONING
❑ Imposition of upper limit on credit available to
large firms/industries
❑ Charging a higher or progressive interest rate on bank loans beyond a certain limit
◼ Change in lending margins
◼ Moral Suasion
◼ Direct controls
Econtent on Monetary Policy
◼ https://www.youtube.com/watch?v=5hgPpX7H_Ak
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