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SESSION 9

Reading
1. This set of slides
2. From the text material
Chapter - 5

Demand for Money


Two sources of demand 1.

Transaction demand for money to carry out current


transactions
TDM = k. P. Y, where k > 0
Or
TDM / P = k. Y

2. Speculative demand for money If interest rate falls


bonds become less attractive, demand for money rises
SDM = A - Hr
Combining the two motives demand for money is given
by
MD / P = A/p + k. Y H/p. r = a + kY - hr

r
M

D
D
Y
hr 1 / 2 /P
P -h =
= r
a
a
+
+
k.
k.
Yo
-

MD/P
As income Y increases, from Yo to Y
Tr. Demand for money rises at each level of interest rates;
hence total money demand also increases at each level of interest
rates.
As interest rate r rises, speculative demand for money falls
following the money demand curve;
hence total demand for money also falls.

Money Market Equilibrium

The Money Market is in


equilibrium if
Money Demand = Money
Supply
At point E
MD = MDo , MS = MS1,and r =
r0
and MDo = MS1
Therefore E is the equilibrium.

MS1
MD

r0

MS
1
MDo

MD

Is the money market always in equilibrium?


Suppose the money market is
not on equilibrium. This is
possible if interest rate is too
high, say r1.
At interest rate r1, the public is
tempted to buy bonds.
Money demand = MD
< Money Supply = MS1

r
r1

MD
A

ro

MS1
B

But will this situation be


sustained?
MD

MS
1
MDo

MD

A situation where MS > MD


implies that people have more cash
on hand than they want.
what do they do with this cash?
.. Use it to save for the future and
earn interest at the same time
that is use it to buy bonds.
r
Demand for bonds
price for bonds
r1
bond sellers interest rates
interest rates from r1
as interest rates bonds
ro
become less attractive &
speculative demand for money
Total demand for money
This continues as long as there is
any excess supply of money.
Eventually interest rate drops to ro
from r1, and MD equates MS.
and the equilibrium is restored.

MD
A

MS1
B

MS
1
MD MDo

MD

Is the money market always in equilibrium? cont.

Suppose the money market is


not on equilibrium. This is
possible if interest rate is too
low, say r2.
At interest rate r2, the public is
tempted not to buy bonds and
keep their assets as money.
Money demand = MD*
> Money Supply = MS1
But will this situation be
sustained?

MD

MS1

ro
r2

MS
1
MDo MD*MD

A situation where MS < MD


implies that people have less
cash on hand than they want.
what do they do now?
.. Sell bonds to get the money.
Demand for bonds
price for bonds
bond sellers interest rates
interest rates from r2
as interest rates bonds
become more attractive &
speculative demand for money
Total demand for money
This continues as long as there is
any excess demand of money.
Eventually interest rate rises to ro
from r2, and MD equates MS.
and the equilibrium is restored.

MS1
MD
E

ro
r2

D
MS
1
MDo MD* MD

Is the money market always in equilibrium?

The money market may not be


on equilibrium.
But the money market will
eventually MOVE TO the
equilibrium.

Relation between Aggregate Income Y and interest


rate r in the money market
Y
Transaction demand for money
(TDM)
Money Demand (MD)
MD > Money Supply MS
(disequilibrium in the money
market)
in want of cash people sell off
bonds
demand for bonds
Price for bonds
Interest rates
MD to match MS (back to
Therefore Y r
money market equilibrium)
This direct relation
between Y r is
depicted as the LM
curve.

r
LM
r2

r1

Y1

Y2

LM curve and Money Market equilibrium

r
LM
r2

r1

MD < MS
B

Y1

D
MD > MS

Y2

LM curve and Money Market equilibrium

On every point on the LM curve


the money market is on
equilibrium.

Say the money market is in


equilibrium with Y = Y1 and r = r1
(point A)

r
LM
r2

Now as r to r2 SDM MD
below MS, the money market
moves to point B where MD < MS.
r1
Similarly on any point on the left
hand side of the LM curve, MD <
MS.

Say the economy is in


equilibrium with Y = Y2 and r = r2
(point C)

Now as r to r1 SDM MD

MD < MS
B

Y1

D
MD > MS

Y2

Monetary Policy
Monetary policy is defined as a
deliberate change in the money
supply made by the government.
Instruments of monetary policy (will be
discussed shortly) are changes in
- cash reserve ratio,
- reserve deposit ratio,
- bank rates
- repo rates
- or open market sells and purchase of
bonds.

Effect of increase in MS on the money market


Suppose initial money supply is
MS1. The money market is in
equilibrium at E with interest
rate r1.
Now Money supply increases to
MS2.
excess supply of money
(length EB) at interest rate r1
demand for bonds
price for bonds
interest rates to r2
bonds become unattractive
speculative demand for
money
Total demand for money to
MD2

MS1

MS2

MD
r1
r2

B
E

MS
MS
1
2
MD1 MD2MD

Increase in the Money Supply and Shifts in LM curve

So.
An increase in money
supply causes interest
rates to to r2
Investment
C+I+G
AD
Y
If the economy was initially
at L (r1, Y1) it moves to L
(r2, Y2).
If the economy was initially
at M (r3, Y3) it moves to M
(r4, Y4).
Joining Land M we get a
new LM curve shifted down
and rightward from the initial
LM curve.

r
LM
L

r1
r2
r3
r4

LM

M
M

Y3 Y4Y1 Y2

Credit Creation

CIRCULATION OF MONEY

The
reserve
deposit
ratio =
1.
Depos
it
Rs.10
00
Individual
1

The cash
The
reserve
Central
Bank (RBI) ratio =

The
The
Commercial
Commercial
Bank (SBI
Bank (HDFC
Say)
Say)

Individual
2

Individual
3

Individual
4

Money in circulation = Rs. 1000

CIRCULATION OF MONEY

The
reserve
deposit
ratio

1.
Deposit
Rs.1000
Individual
1

The
The cash
Central
reserve
Bank (RBI) ratio
The
The
Commercia
Commercial
l Bank
Bank (HDFC
(SBI Say)
Say)
3.
Balan
ce Rs.
200
2. Loans
Rs.800
Individual
2

Individual
3

Individual
4

Money in circulation = Rs. 1000 + Rs.800

CIRCULATION OF MONEY
The
Central
Bank (RBI)
The
The
Commercial
Commercial
Bank (SBI
Bank (HDFC
Say)
Say)
3.
Balance
6. Loans
Rs. 200 5. Deposit
2.
Loans
1.
Rs.640
Rs.800
Rs.800
Deposit
Rs.1000
Individual
1

Individual
2

Individual
3

Individual
4

4. Transaction of
Rs.800
Money in circulation = Rs. 1000 + Rs.800 + Rs.640

CIRCULATION OF MONEY
The
Central
Bank (RBI)
The
The
Commercial
Commercial
Bank (SBI
Bank (HDFC
7.
Say) 3.
Say)
Balance
Balance
Rs. 160
Rs.
200
1. Deposit
6. Loans
5. Deposit
2.
Loans
Rs.1000
Rs.640
Rs.800
Rs.800
Individual
1

Individual
Individual
Individual
2
3
4
4. Transaction of
Money in circulation =Rs.800
Rs. 1000 + Rs.800 + Rs.640

CIRCULATION OF MONEY
The
Central
Bank (RBI)
The
Commercial
Bank (SBI
Say) 3.
Balanc
e Rs.
1. Deposit
200
Rs.1000
2. Loans
Rs.800
Individual
1

The
Commercial
Bank (HDFC
7.
Say)
Balance
Rs. 160
6. Loans
5.
Rs.640
Deposit
Rs.800

Individual
Individual
Individual
2
3
4
4. Transaction of
Rs.800
8. Transaction of
Money in circulation = Rs. 1000
+ Rs.800 + Rs.640
Rs.640

CIRCULATION OF MONEY
The
Central
Bank (RBI)
The
The
Commercial
Commercial
Bank (SBI
Bank (HDFC
7.
Say)3.
Say)
Balance
Balanc
Rs. 160
9.
e
Rs.
1.
6.
Deposit
2.
Loans
200
Deposit
Loans
Rs.640
Rs.800
5.
Rs.1000
Rs.640
Deposit
Rs.800
Individual
Individual
Individual
Individual
1
2
3
4
4. Transaction of
Rs.800
8.
Transaction of
Rs.640
Money in circulation = Rs. 1000
+ Rs.800 + Rs.640

CIRCULATION OF MONEY
The
Central
Bank (RBI)
The
The
Commercial
Commercial
Bank (SBI
Bank (HDFC
7.
Say)
Say)
9. Deposit
Balance
Rs.640
Rs. 160
1.
10.
6.
2.
Depos
Loans
Loans
Loans
5.
it
Rs.512
Rs.640
Rs.80
Deposit
Rs.10
0
Rs.800
00
Individual
Individual
Individual
Individual
1
2
3
4
4. Transaction of
Rs.800
8. Transaction of

Money in circulation = Rs. 1000 + Rs.800


Rs.640 + Rs.640 +

Monetary aggregates

&

money multiplier

M0:
Notes and coins (currency) in circulation and in bank vaults.
In some countries, such as the United Kingdom, M0 includes
bank reserves, so M0 is referred to as the monetary base,
or narrow money.

MB:
M0 + reserves which commercial banks hold in their
accounts with the central bank
MB is referred to as the monetary base or total currency or
Central Banks money.
This is the base from which other forms of money (like
checking deposits) are created and is traditionally the most
liquid measure of the money supply.

M1:
M1 includes funds that are readily accessible for spending.
M1 consists of:
(1) currency in circulation outside Central Banks, and the
vaults of depository institutions;
(2) traveler's checks of nonbank issuers;
(3) demand deposits (current account)
etc.
Bank reserves are not included in M1.

M2: money and "close substitutes" for money


It includes
1. M1
2. savings deposits,
3. small amount fixed deposits
4. money market deposit accounts for individuals.
. Economists use M2 when looking to quantify the amount
of money in circulation and trying to explain different
economic monetary conditions. M2 is a key economic
indicator used to forecast inflation.

M3includes
1. M2
2. large time deposits
3. institutionalmoneymarketfunds,
4. short-term repurchase agreements and
5. other larger liquid.

Money multiplier
MM
= Total amount of money in circulation / central banks
monetary base
= M2/MB

In hand

Com.
Bank
vaults

With
RBI

Reserve

In hand

ar
t
e
on
M

se
a
yb

Bank deposit

2
M

c.M
d
In hand

.(1Com.c).Md
With
Bank
RBI
vaults

r
ta
e
on
M

Reserve

se
a
yb
2
M

In hand

Bank deposit

c.M
d

(1-c).Md
Md

= R / D = reserve deposit ratio


R = reserve of banks
D = total amount of checkable deposits

People hold a fixed proportion of money in currency


c = CUd / Md
CUd = demand for currency (money in hand)
Md = demand for money
So, demand for deposits = Dd = (1-c) Md
and demand for reserves
Rd = .Dd = (1-c) Md
Demand for central banks high powered money =
Hd = CUd +Rd = c.Md + (1-c) Md
Money multiplier = Md / Hd = 1 / [c + (1-c) ]
MM > 1

3. CRR and SLR calculations: Are they separately


calculated ?
Non bank deposits
= Rs. 900

Non bank loans


forwarded = 1200

Borrowing from other


banks
= Rs. 400
Interbank assets
= Rs. 100

Net demand and time liabilities


= total liabilities (900+400) [ interbank assets]
= total liabilities (1300) [interbank asset (100)]
= 1200
CRR = 5% of NDTL fortnightly = Rs. 60 (to be sent to RBI)
SLR = at least 21.5 % of DTL (1300) on a daily basis
and 21.5% of NDTL on the second fortnight