Money Supply

Money Supply
• Monetary base (or high powered money) (H):
H = Currency held by the public (excluding that held
by banks) (CU) + Reserves of the commercial banks
(R).
• Reserves = Balance of commercial banks at the central
bank + currency held by commercial banks.
• Money supply (broad money), M
M = Currency held by the public (excluding that held
by banks) (CU) + deposits of public held with
commercial banks (D).
 Money supply

M = CU+D (1)
H = CU +R (2)
Dividing (1) by (2), we get
M/H = (CU+D)/(CU+R)
• Divide each term in numerator and denominator by D
on the RHS
M/H = (cu+1)/(cu+re) (3)
cu = CU/D = currency to deposit ratio, re =R/D
reserves to deposit ratio.
• (cu+1)/(cu+re) is called money multiplier (mm).
 Money supply
• (cu+1)/(cu+re) is called money multiplier (mm).
• Aug. 30, 2019. M0=Rs. 2783158 Cr., M3= Rs.
15677092 Cr.
Money multiplier: 5.63
• If high powered money(H) is increased by Re.1
overall money stock (M) will increase by Rs.5.63
• Higher the ‘cu’ _________ (higher/lower?) money
multiplier
• Higher the ‘re’ ________ (higher/lower?) money
multiplier
 Money supply
• The process by which money stock expands due to
an increase in monetary base is called credit
creation.
• An increase in monetary base leads to a series of
deposit creations via the banking system resulting
in increase in money stock by proportion larger
than the increase in H
• Balance sheet of RBI and Commercial banks
 RBI injects 600 Crores (buys G-secs from public)

H = 600cr cu= 0.5, re=0.1

What is the
CU=200 D=400 money
multiplier?

L=360 R=40

CU=120 D=240

L=216 R=24
 Money supply
Currency-deposit ratio
• Currency to deposit ratio depends on the
public’s preference to hold cash and deposits.
• This ratio will be determined by the following
factors:
– Cost and convenience of getting cash
– Festivals and seasons
 Money supply
Reserves to deposit ratio
• It summarises the behaviour of banks.
• Reserves = required reserves + excess reserves
Required reserves is the reserve to be kept as per the
statute. Excess reserves is the choice of banks.
• Reserve ratio, ‘re’, depends on the following factors:
Required reserves ratio (CRR)
Market interest rate: -vely related
 Money supply
Instruments of monetary control
• Open market operations. It refers to the sale and
purchase of govt. securities by the central
bank(CB).
Sale leads to decrease in H and M
Purchase leads to increase in H and M
 Money supply
Instruments of monetary control
• Discount rate (RBI’s repo rate).
• Repo rate is the rate at which RBI lends to commercial
banks for meeting short term liquidity needs.
• Lending under repo increases the monetary base as
funds are credited to the reserves a/c with RBI.
• More importantly, it has signalling effect to the market.
 Money supply
Instruments of monetary control
RBI as lender of last resort
• This is an important function of central bank.
During the thick of sub prime crisis, central
banks all over world committed unlimited funds
to the banks to avoid any panic.
• Under such circumstances, the repo window of
RBI will provide unlimited funds to the
commercial banks.
 Money supply
Instruments of monetary control
• Required reserves ratio (CRR). If RBI raises
this ratio, ‘re’ will rise, money multiplier will
fall and hence money supply will fall.
• If CB lowers CRR, ‘re’ will fall, money
multiplier will rise and hence money supply will
rise.
 Money supply
Government’s budget deficit and money supply
• Borrowing from the central bank: Increases H
and M.
• Borrowing from the public. No change in
money supply.
 Money supply
Forex market interventions
• Purchase of forex leads to increase in H,M, Sale
leads to reduction in H and M
• Sterilization means conducting open market
operations to neutralize the effect of foreign
exchange operations of central bank on money
supply.
SUB PRIME CRISIS AND INDIA’S MONETARY POLICY
India: Overall Inflation - WPI
SUB PRIME CRISIS AND INDIA’S MONETARY POLICY
India: Repo rate

8.5

7.5

6.5

5.5

4.5
 SUB PRIME CRISIS AND INDIA’S MONETARY POLICY

CRR
9.00

8.00

7.00

6.00

5.00

4.00
30.08.2008 11.10.2008 15.10.2008 01.11.2008 08.11.2008 05.01.2009 17.01.2009 04.03.2009
 RBI’s COVD response

Repo rate cut: In March 2020 from 5.15 to 4.40:

Further in May 2020 from 4.4 to 4.0

March CRR cut to 3%.

CRR increased to 3.5% on March
27, 2021. Again to 4% on May 22,
2021.
 RBI : KEY POICY RATES & RESERVE RATIOS

  Oct. Sept. Sept., Oct. Oct. Oct. Oct Nov.

1990 2020
2011 2012 2014 2015 2016 2018 2019
Repo rate - 8.5 8 8 6.75 6.25 6.5 5.15 4%
CRR 15 6 4.5 4 4 4 4 4 3%
SLR 38.5 24 23 22 21.5 20.75 19.5 18.50 18%