Money, Money Supply, and

Money Demand
Session 6, 7 and 8
 What is money?
• In economics
– money = medium of exchange
– Whatever is accepted in exchange

• What if the goods are directly exchanged (barter).

– Farmer sells food to tailor in exchange of cloths
– Farmers sells food get money, go to tailor and buy cloths
– Would it be better because you are reducing the steps involved in
transaction

• Double coincidence of wants

– Difficult to find a barber who is interested in listening economics
lectures
 Money helps in facilitating transactions

Money is the yardstick with which we measure

economic transactions. Without it, we would be
forced to barter. However, barter requires the
double coincidence of wants—the unlikely
situation of two people, each having a good that
the other wants at the right time and place to make
an exchange.

Thus, money provides a unit of account

 Distinction between Money and Wealth
• Money refers to the items which can be used for transactions
– to the stock of assets held as cash, checking accounts, and
closely related assets, specifically not generic wealth or income
– Concept of liquidity is associated with the concept of money
• The ease at which an asset can be converted into a medium of exchange
and used to buy other things is sometimes called an asset’s liquidity.
Money is the most liquid asset.
 Why does anyone want it?
The Functions of Money
• Medium of exchange
– Money is used to pay for goods and services
– Eliminates the need for a “double coincidence of wants”

• Store of value
– An asset that maintains value, transfers purchasing power from present to future
– If money were not a store of value, it would not be used as a medium of exchange.
It essentially store purchasing power (thought not perfectly due to inflation) to
buy goods in future.

• Unit of account
– The unit in which prices are quoted

• Standard of deferred payment

– Money units are used in long term transactions (ex. loans)
 Types of Money
Commodity money is money that
has intrinsic value.

When people use gold as money, the

economy is said to be on a gold standard.

Fiat money is money by declaration.

It has no intrinsic value.
 Development of Money: Commodity Money
• Commodity money
– People started to use commodities which could have some uniformity or
standardization
• Cattle, Stones, seashell, cigarettes, gold, silver etc.

• Issues
– For low value commodity, you require large amount (physically)of money to
make transactions
– Also, transporting money was not easy. Verifying the quality of money was costly

• Some solutions
– Government minted coins of gold and silver for uniformity
• You bring your metal at mint and get your money minted (19th Century India)
– Goldsmith banks evolved that stored the gold and in return gave certificate which
could be used for transactions
Development of Money: Commodity Money
• The government also started accepting gold from the
public in exchange for gold-certificates— pieces of
paper that can be redeemed for actual gold.
• Prior to civil war in US, individual banks were
issuing notes leading to great confusion

• If people trust that the government will give them the

gold upon request, then the currency will be just as
valuable as the gold itself—plus, it is easier to carry
around the paper than the gold.

• The end result is that because no one redeems the

gold anymore and everyone accepts the paper, they
will have value and serve as money.
 Development of Money: Fiat Money
• Today money is not backed by any physical asset.
• Hence, there is no intrinsic value of the money.
• Yet the notes says that I promise to pay the bearer
sum of X Rs.
 Development of Money: Fiat Money
• Today money is not backed by any physical asset.
• Hence, there is no intrinsic value of the money.
• Yet the notes says that I promise to pay the bearer
sum of X Rs.
• You can get new piece of paper in exchange of the
old paper.
 Development of Money: Fiat Money
• It helps in avoiding the sharp fluctuations of money supply
depending upon the new discoveries of the metal

• Fiat money helps in reducing the scarcity of the money supply

and provide greater control to the government,
– It provide a tool the government in form of monetary policy for
macroeconomic management

• It saves real resources (labour and capital) which otherwise had

to be engaged in creating (mining) money
– Columbus
– Mughals and Mewar
– Roman empire and ancient India
But it can be dangerous if printed excessively,
will lead to hyperinflation.

This threat was also relevant for the commodity

money when there was new discovery of metal
leading to increase in money supply.
Different Ways to Measure the Quantity of Money in India

• M0 : Currency in circulation + Bankers’ deposits with the RBI + ‘Other’

deposits with the RBI
(High Powered Money)

• M1: Currency (notes and coins with public) + Demand deposits (current and
saving deposits)
• M2: M1 + office savings banks
• M3: M2 + time deposits
– M1 is called as the narrow money while M3 is defined as broad money.

• You may see that M1 is more liquid than M3.

• Though, with introduction of debit cards, ATM, and online banking the
gap in liquidity differential has reduced over time.
https://m.rbi.org.in/Scripts/PublicationsView.aspx?id=9455
https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=19773
How the Money Supply is Determined

M=C+D
Money Supply Currency Demand Deposits

Money supply is determined not only

by the Reserve Bank, but also by the behavior of households
(which hold money) and banks (where money is held).
The role of fractional reserve system
 100-Percent-Reserve Banking
• The deposits that banks have received but have not lent out are
called reserves.

• Consider the case where

– all deposits are held as reserves
– banks accept deposits, place the money in reserve
– leave the money there until the depositor makes a withdrawal or writes
a check against the balance.
– Or issues bank note backed by the deposits

• Does the amount of money supply changes due to banking system

 100-Percent-Reserve
• In a 100-percent-reserve banking system, all
deposits are held in reserve; thus the banking
system does not affect the supply of money.

A Sample 100-Percent-Reserve Bank Balance Sheet

Assets Liabilities
Reserves Deposits certificates
$1,000 $1,000
 Fractional-Reserve Banking
• As long as, all the depositors are not coming together to
demand their deposits, a bank need not keep all its deposits
in reserves.

• The banks can issue more notes/certificates than the deposits.

• Earlier, they use to charge interest for deposits, now they could
give the interest on deposits.
 Fractional-Reserve Banking
• The banks maintains a fraction of their deposits as
reserves to meet the withdrawal demand of the
depositors, and lent out the rest of the money

• A reserve-deposit ratio is the fraction of deposits kept

in reserve.

• Thus, under Fractional-reserve banking, banks keep

only a fraction of their deposits in reserve. Effectively,
banks create money.
 Fractional-Reserve Banking

A Sample Fractional-Reserve Bank Balance Sheet

Assets Liabilities
Reserves $200 Deposits certificates
Loans $800 $1,000

Total amount of money available for transactions: Deposit

certificates + Loans (that are available with the borrower
in form of currency)
 Fractional-Reserve Banking
• Assume each bank maintains a reserve-deposit ratio
(rr) of 20 percent and that the initial deposit is
$1,000.
Third bank
First bank Second bank Balance Sheet
Balance Sheet Balance Sheet Assets Liabilities
Assets Liabilities Assets Liabilities
Reserves $200 Deposits $1,000 Reserves $160 Deposits $800 Reserves $128 Deposits $640
Loans $800 Loans $640 Loans $512

What would be the level of total deposits.

What would be the level of total loans.
 Fractional-Reserve Banking
• Mathematically, the amount of money the original
$1000 deposit creates is:
– Original Deposit =$1,000
– First bank Lending = (1- re)  $1,000
– Second bank Lending = (1- re)2  $1,000
– Third bank Lending = (1- re)3  $1,000
– Fourth bank Lending = (1- re)4  $1,000
• Total Money Supply = [1 + (1-re) + (1-re)2 + (1-re)3 + …] 
$,1000
= (1/re)  $1,000 = (1/.2)  $1,000 = $5,000
Or the base money multiplies by (1/reserve ratio) times
The above example assumes that households does not prefer to keep cash
with them and keep their entire “money” in form of deposits.
 The Money Multiplier

M
M= m  BB
=m

Money Supply Money multiplier Monetary Base

Because
Becausethe
themonetary
monetarybase
basehashasaamultiplied
multipliedeffect
effecton
onthe
themoney
money
supply,
supply,the
themonetary
monetarybase
baseisisalso
alsocalled
calledas
asthe
thehigh-powered
high-poweredmoney.
money.
 Money Stock Determination
(When Public holds currency)
• The RBI has direct control over high powered money (H)
• Money supply (M) is linked to H via the money multiplier
– Bottom of figure is the stock of high-powered money = monetary base
• Money multiplier (mm) is the ratio of the stock of money to the
stock of high powered money  mm > 1
– The larger deposits are, as a fraction of M, the larger the multiplier

[Insert Figure 16-2 here]

 Money Stock Determination

• Money supply = (Currency + deposits ) =

• High powered money (H) = (currency + reserves) =

• Money multiplier (mm):

• Lets define:
– Currency-deposit ratio:

– Reserve ratio:

• Money multiplier =
 Money Stock Determination
• Some observations of the money multiplier:

• Smaller the reserve ratio, re: Larger the money multiplier

• Smaller the currency-deposit ratio, cu: Larger the money multiplier
• The smaller is cu, the smaller the proportion of H that is being used as
currency AND the larger would be the proportion that is available to be
reserves
• Currency creates only 1 unit of money (M3) against one unit of high-powered
money (M0) . While reserve can create 1/re amount of money (M3) .

• Three exogeneous variables (cu, ru, and M0) determines (M3)

 The Currency-Deposit Ratio
• The payment habits of the public determine how much
currency is held relative to deposits
• The currency-deposit ratio is affected by the cost and
convenience of obtaining cash
• Currency-deposit ratio falls with shoe leather costs
• Ex. If there is a cash machine nearby, individuals will on average
carry less cash with them because the costs of running out are lower
• Introduction of ATM and online banking would reduce the
currency-deposit ratio, thus raise the money multiplier.
• The currency deposit ratio has a strong seasonal pattern
• Highest around Diwali/Christmas
 The Reserve Ratio
• Bank reserves = deposits banks hold at the Reserve Bank + “vault cash,”
notes and coins held by banks
• In absence of regulation, banks would hold reserves to meet
– The demands of their customers for cash
– Payments their customers make by checks that are deposited in other
banks

• Banks may hold some excess reserves over and above legal requirements to meet
unexpected withdrawals which otherwise could bring down their reserve ratios
below legal requirements
• Reserves (in India) earn no interest, so banks try to minimize excess reserves,
especially when interest rates are high
(In the US, the Fed started paying interest on reserves after 2008 financial crisis. The current
interest rate is 0.1 %).
 Calculate Money Multiplier
• If the required reserve ratio is 8%, the excess reserve
ratio is 2%, and the currency-deposit ratio is 30%,
what is the value of money multiplier?

• What to do with excess reserves for calculations?

• M/H = mm = (1 + cu)/(cu + re).

• mm = (1 + 0.3)/(0.3 + 0.08 + 0.02)
= (1.3)/(0.4) = 3.25.
 Does money multiplication increase the
wealth
• Money multiplication process increases:
A) Money Supply
B) Deposits and loans
C) Wealth
D) Liquidity

Answer: Only A, B. and D.

Each asset creation also generate a corresponding
liability. So money supply has no effect on wealth.
 Money Stock Determination (Review)
• The money supply consists of currency with public and
deposits at banks
– A key concept concerning money is the fractional reserve banking
system: banks required to keep only a fraction of all deposits as reserve

• High powered money (monetary base) consists of currency

and banks’ deposits at the RBI
– The part of the currency held by the public forms part of the money
supply
– Currency in bank vaults and banks’ deposits at the RBI are used as
reserves backing individual and business deposits at banks (Does not
form part of money supply)
 Banks vs Other Financial Intermediaries
• The process of transferring funds from savers to borrowers is
called financial intermediation.

• Notice, that banks are the only financial intermediary who can
create money by making loans

• Presume that you lend money Tata by corporate bonds. Tata can
use that money to buy cement, but you cannot use the piece of
the corporate bond to purchase goods in a grocery shop

• Presume you lend your money to a bank (deposit), a fraction of

which the bank lent out to Tata. The Company can use that loan to
buy cement, while you can use your deposits to buy toothpaste
 Central Bank and Bank Reserves
•The Central Bank is The Banks’ Bank. The Central Bank
operates a clearinghouse for bank checks. Each member
bank has an account with the Central Bank.

•The deposits that banks have with the RBI/Fed are

called reserves/federal funds

•A check written against private bank A and deposited with

private bank B reduces bank A’s reserves and increases
bank B’s reserves.
See https://www.rbi.org.in/scripts/FS_Overview.aspx?fn=2758
 Bank Reserves and inter-bank Call rate
• Reserves are the deposits of private banks with the CB/RBI. The banks are
legally required to keep some reserves measured as fraction of their
deposits.

• The banks may have surplus/deficit in their reserve against the

requirement

• The reserves’ market consists of private banks borrowing and lending

their reserves amongst each other overnight
• The inter-bank-call rate is the interest rate on these overnight loans. It is
set by supply and demand, not by the CB.
• But the Central Bank can change the supply of reserves through open
market operations, exerting a powerful indirect effect on the inter-
 Calculate the market price of an asset
given the rate of return
• Let’s assume that you invested Rs 1000 in a bank at 10% interest/year
for entire life.

• Bank changed the interest rate, and if you now invest fresh Rs 1000, you
will get 8% interest only on incremental deposits.

• What is the current value of your initial investment ?

• What is the interest payment that you are getting currently

– Rs 100/year
• How much you need to invest now to get Rs 100 as interest payment per
year
X = Coupon/new yield
Relationship between Interest rate and Bond
Price
• Bonds: Borrowers (government or corporate)
issue bonds to raise debt. These bonds are
bought by creditors, who can resell them.

• Let’s say a bond gives you fixed return per year

• If the interest rate fall the bond price will ?
• If the interest rate rise the bond price will ?
• Price of bond is inversely related to interest rate
 Think for a bank’s perspective
(Reduce money supply)
• Let’s assume that central bank want to increase the interest rate
and reduce money supply
– It offers to sell bonds, thus raising the supply and reducing prices of bonds
– Bondholders (including the commercial banks) find the earlier bond price
unattractive. They buy bonds from the central bank only at a lower price;
i.e. central bank need to offer them higher interest rate
– Banks receive bonds from the central bank in exchange for high powered
money.
– This reduces the high powered money available with the banks for
lending, increasing the interest rate

• Reverse will be the case when the central bank wants to increase
the money supply
 Think for a bank’s perspective
(Increase money supply)
• Let’s assume that central bank want to reduce the
interest rate and increase money supply
– It offers to buy bonds, thus raising the demand and prices
of bonds
– Bondholders (including the commercial banks) find the
new bond price attractive. They sell bonds to the central
bank in exchange for high powered money.
– This raises the money available with the banks for lending,
reducing the interest rate
 Tools for Central Banks for Influencing
Money Supply
• Three instruments for controlling money supply
1. Required-reserve ratio (Cash Reserve Ratio: CRR)
• Portion of deposits commercial banks are required to keep on hand,
and not loan out

2. Open market operations

• Buying and selling of government bonds

3. Discount rate/ Bank Rate

• Interest rate the central bank “charges” commercial banks for
borrowing money as the lender of last resort for commercial banks
 The Reserve Ratio
• The Federal Reserve/RBI sets the required reserve ratio:
– the portion of each deposit commercial banks must keep
on hand
• Central Bank can increase the money supply by reducing the
required reserve ratio (CRR):

• The CRR was preferred tool in till 1990s when the SLR was
very high and bond markets were not liquid
• Currently, it is not a preferred policy tool as it it can be
calibrated and timed according to liquidity conditions
 Open Market Operations (OMOs)
• The Central Bank manages money supply through OMOs
– Purchase government bonds: To add money supply (increase liquidity)
– Sell government bonds in the open market: To reduce money apply (absorbs
liquidity)

• Outright Purchase (PEMO): RBI out-rightly engages in purchasing and

selling of securities for expanding or contracting the money-supply for
a long-term.

• Repurchase Agreement ( REPO): RBI through REPO engages in

securities sale or purchase with a condition to repurchase
 Open Market Operations
• Repo
– Central bank buys government bonds from the commercial banks
and create currency to pay the banks. This currency becomes part
of high-powered money and start money multiplier model.

• Reverse Repo
– Central bank sells the bonds and in return commercial banks gives
currency to the central bank. Now bank has less currency. To
maintain the reserve ratio (currency in vault/held at central bank
as % of the deposits), banks need to reduce their loans.

• NOTE: The Central Bank can create H at will by buying assets or

reduce H by selling assets
 Repo (assume the cu and re in stage 0 remains constant)
Commercial Bank's Balance Sheet (Stage 0)
RBI’s Balance Sheet (Stage 0) Demand
Government Currency held Reserves 100 Deposits 1000
Securities 200 by Public 200 Loans 600   
Other Assets 100 Bank Reserves 100 Government
Securities 300   

RBI buys government securities worth 6 Cr from the banks

Commercial Bank's Balance Sheet (Stage 1)
RBI's Balance Sheet (Stage 1) Demand
Currency held Reserves 106 Deposits 1000
Securities 206 by Public 200 Loans 600   
Other Assets 100 Bank Reserves 106 Government
Securities 294   

Banks start making fresh loans, a part of which is retained by the public as cash, remaining is
deposited back, banks keep required reserves and lent out the rest (process continues)
Commercial Bank's Balance Sheet (stage 2)
RBI's Balance Sheet (Stage 2) Demand
Currency held Reserves 102 Deposits 1020
Securities 206 by Public 204 Loans 624   
100 102 Government
Other Securities 294   
Assets Bank Reserves
 Repo

• Impact of the Central Bank buying Rs 6 Cr of government bonds on the

Central Banks's balance sheet:
– Ownership of securities increases by Rs 6 Cr
– Central bank credits the account of commercial bank which raises the commercial
bank’s reserves by Rs 6 Cr.

• Impact on Commercial banks’ balance sheet

– Banks realize that they have excess reserve of Rs 6 Cr, which they can lend entirely.
– With this lending, the process of deposit-lending (multiplication) begins. By the end
of process, fresh Rs 24 Cr loans and Rs 20 Cr deposits are created.
– Banks retain Rs 2 Cr as reserves for reserve requirements against new Rs 20 Cr
deposits.

• Overall Impact
– Households’ cash holding goes up by Rs 4 Cr, while the total money supply goes up
by Rs 24 Cr
 Repo
Round Loan Reserve Cash Deposits
1 6   1 5
2 4.5 0.5 0.75 3.75
3 3.375 0.375 0.5625 2.8125
 - - - - -
 - - - - -
 Sum 24 2 4 20

Total loan: 6 *(1/1-0.75) = 24

Reserve: 0.5 * 1/1-0.75) = 2
Total cash: 1 * (1/1-0.75) = 4
Total deposits: 5 * (1/1-0.65) = 20
 Reverse Repo
Commercial Bank's Balance Sheet (stage 2)
RBI's Balance Sheet (Stage 2) Demand
Currency held Reserves 102 Deposits 1020
Securities 206 by Public 204 Loans 624   
100 102 Government
Other Securities 294   
Assets Bank Reserves
RBI sells government securities worth 6 Cr to the banks
Commercial Bank's Balance Sheet (Stage 3)
RBI's Balance Sheet (Stage 3) Demand
Currency held Reserves 96 Deposits 1020
Securities 200 by Public 204 Loans 624   
Other Assets 100 Bank Reserves 96 Government
Securities 300   

Banks start reducing their lending to boost reserves. Any repayment to the bank reduces both
lending as well as deposits/cash in the system. Thus, both lending and deposits come down,
while reserves increases
Commercial Bank's Balance Sheet (Stage 4)
RBI’s Balance Sheet (Stage 4) Demand
Government Currency held Reserves 100 Deposits 1000
Securities 200 by Public 200 Loans 600   
Other Assets 100 Bank Reserves 100 Government
Securities 300   
 Reverse Repo

• Impact of the Central Bank selling Rs 6 Cr of government bonds on the

Central Banks's balance sheet:
– Ownership of securities reduces by Rs 6 Cr
– Central bank debits the account of commercial bank which reduces the commercial
bank’s reserves by Rs 6 Cr.

• Impact on Commercial banks’ balance sheet

– Banks realize that they have less reserve than the requirement. They call in some
short-term loans/reduce their lending to augment their reserves
– With this reduction in lending, the process of deposit-lending (multiplication)
reverses. By the end of process, loans decline by Rs 24 Cr and deposits decline by Rs
20 Cr.
– Banks reserves are replenished to the legal requirement.

• Overall Impact
– Households’ cash holding decline by Rs 4 Cr, while the total money supply reduces
by Rs 24 Cr
 CRR vs OMO
• Both have impact on money supply

• CRR focus on money multiplier

• OMO focus on monetary base

 Calculate Change in Money Supply
• If the required reserve ratio is 8%, the excess reserve ratio is
2%, and the currency-deposit ratio is 30%, by how much would
money supply change if the Fed made open market purchase
(Repo) valued at $40 million?

M/H = mm = (1 + cu)/(cu + re).

mm = (1 + 0.3)/(0.3 + 0.08 + 0.02)
= (1.3)/(0.4) = 3.25.
M = mm(H) = (3.25)(40) = 130.

Since an open market purchase valued at $40 million would increase high-powered money
(H) by $40 million, money supply (M) would increase by $130 million.
Quantitative Easing and Exploding Monetary Base
The monetary base has historically grown relatively
smoothly over time, but from 2007 to 2014 it
increased approximately 5-fold. The huge expansion
in the monetary base, however, was not
accompanied by similar increases in M1 and M2

While the monetary base increased about 400

percent from 2007 to 2014, M2 increased by only
55 percent.
 The Reserve Ratio may not be effective tool
when there are excess reserves
• Fed began paying interest on required and excess reserves during Great Recession
• During Great Recession, excess reserves grew as risk averse banks made fewer
loans which had a significant impact on the money multiplier
 Discount Rate/Bank Rate
• A bank that runs short on reserves can borrow to make up the difference
• Can borrow either from commercial banks (inter-bank market) or the
Fed (as lender of last resort)

• The cost of borrowing from other banks is the federal funds rate
– Federal funds are reserves that some banks have in excess and others
need

• The cost of borrowing from the Fed/RBI is the discount rate/bank rate
– Discount rate is usually 0.25 to .5% higher than the target federal
fund rate. Hence, it acts as a cap on inter-bank interest rate

• Discount rates are rarely used as a monetary policy tools.

– In 2007-09 crisis, Fed used discount rate to replenish bank reserves
when inter-bank market was not functioning.
 Bank Capital, Leverage
and Capital Requirements
Starting a bank requires financial resources to get the bank
started; the equity of the bank’s owners is called bank capital.

Here is what a bank’s balance sheet would look like:

Assets Liabilities and Owners’ Equity

_________________________________________________

Reserves 200 Deposits 750

Loans 500 Debt 200

Securities 300 Capital (Owner’s Equity) 50

Some comments on the Balance sheet of the
banks
• The assets (reserves, loans, and Securities) on the left side of the balance
sheet must equal, in total liabilities (deposits, debt, and capital) on the right
side.

• The leverage ratio is the ratio of the bank’s total assets (the left side of the
balance sheet) to bank capital (the one item on the right side of the balance
sheet that represents the owner’s equity).

• Leverage is use of borrowed money to supplement existing funds for

purposes of investment

• The implication of high leverage is that, in bad times, a bank can lose much
its capital very quickly. The fear that bank capital may be running out, and
thus that depositors may not be fully repaid is typically what generates bank
runs when there is no deposit insurance.
 Role as Lender of Last Resort
• Financial systems are heavily leveraged, so liquidity mismatch (long-term
assets and short-term liabilities) can create trouble (asset-liabilities
mismatch).

• Banks have assets (long term loans) which are bit illiquid but liabilities are
liquid (deposits are short term): (Liquidity vs Solvency)

• If depositors come to know that their bank does not have sufficient cash,
they may bank run to get their cash back, further worsening situation.

• One bank may have borrowed from other banks, leading to spill over effect
or contagion effect.

• Federal bank may intervene to avoid cascading effects of defaults.

 The Monetary Side of the Great Depression

(Billion USD)

(Billion USD)

• Money supply fell by 28 percent

• Fall in money supply is due to fall in money multiplier, not the base money
• Households were sceptical of keeping money as deposits, while banks were not lending to each other and kept
higher reserves to meet withdrawals (both cu and re increased)
 Deposit Insurance
• Introduced in the US in 1933 (during the Great
Depression)

• To avoid bank-run on the solvent banks

• Introduced in India in 1962 (after failure of failure of

Laxmi Bank and the subsequent failure of the Palai
Central Bank).

• Current limits are Rs 5 Lakh for accounts per bank

https://www.rbi.org.in/scripts/fun_deposit.aspx#:~:text=The%20Deposit%20Insurance%20Corporation
%20(DIC,extended%20to%20functioning%20commercial%20banks.
https://m.rbi.org.in/Scripts/FAQView.aspx?Id=64
 Lessons for the Financial Crisis 2007
• Banks gave loan for houses backed by the house itself. House prices were rising so there was not
much risk of default or under-recovery. Gave loans to even those had no income no job or assets
(NINJA), and backed the loans by house itself.

• Bank “sold” these loans to other financial institutions to get money and make more loans. New
innovation was mortgage backed securities (MBS).

• When the house prices slowed-down, people started defaulting

• Banks seized the houses and auctioned them. Supply of houses increased with falling demand.
House prices fell. Other home loan borrowers found themselves underwater (their house were
worth less than the loans) and defaulted.

• The banks that gave housing loans and financial institutions that have purchased the MBS also
suffered.

• The interbank lending market froze, creating troubles for even solvent banks.

• Fed played the role of lender of last resort, and flooded liquidity in the market by quantitative
easing
 Fiscal Deficit and Monetary Policy
• Fiscal deficit is the excess of government spending (including
transfers) over its tax collection

• The government can borrow from the public by issuing bonds to

meet the deficit

• The other alternative for the government is to print notes

– Borrow from the RBI in by directly issuing bonds to it

• Even if the RBI does not directly buy bonds from the government, it
can buy through the OMOs thus indirectly funding the fiscal deficit
 Statutory Liquidity Ratio (SLR)
• Government borrows to finance its fiscal deficit

• SLR: Percentage of deposits the banks have to

maintain in safe assets like Govt securities/Cash/Gold

• SLR ensures a captive market for the government

securities
Effective Date Cash Reserve Ratio Statutory Liquidity Ratio
11-08-2012 - 23.00 Trends
10-03-2012 4.75 -
11-10-2008 6.50 - in CRR
30-08-2008 9.00 -
3-11-2001 5.75 - and
25-10-1997 9.75 25.00
26-10-1996 11.50 - SLR
16-10-1993 - 34.75
22-09-1990 - 38.50 • During 1980s,
1-07-1989 15.00 - with low interest
25-04-1987 - 37.50 rates on
28-02-1987 9.50 - government
6-07-1985 - 37.00 securities
4-02-1984 9.00 - (sometimes even
25-09-1981 - 34.50 lower than the
21-08-1981 7.00 - cost of deposits),
1-12-1978 - 34.00 more than 50%
29-06-1973 5.00 - deposits were
17-11-1972 - 30.00 invested in assets
5-02-1970 - 26.00 barely covering
16-09-1964 - 25.00 cost of the funds
16-09-1962 3.00 % of NDTL -

11-11-1960 (a) 5% of DL, (b) 2% of TL -

 Under LAF, Banks can borrow upto 0.25% of
their NDTL (net demand and time liabilities)
for overnight under repo window
Liquidity
Adjustment Banks can also borrow under variable rate
Facility
14-day, 7-day repo auctions upto 0.75 % of
(LAF) NDTL for fortnight

Under MSF, a bank can borrow one-

day loans form the RBI, even if it
doesn’t have any eligible securities
excess of its SLR requirement
(maintains only the SLR).

On March 27, 2020 banks were allowed to

avail of funds under the marginal standing
facility (MSF) by dipping into the Statutory
Liquidity Ratio (SLR) by up to an additional
one per cent of net demand and time
liabilities (NDTL), i.e., cumulatively up to 3
per cent of NDTL.
Currency reduces, deposit increases, no change in numerator
Currency reduces, but bank give that money to RBI under reverse repo. So
denominator reduces
Money Multiplier: India, the US, and Europe

https://www.
livemint.com
/Opinion/SZI
sg9ajQjz90d3
rZzf4PP/How
-much-of-
commercial-
bank-money-
is-being-
created-by-
one-un.html

Guess why the US has a smaller money multiplier than India

DFS, page 382
 Target is to keep the WACR (Weighted Average Call
Rate) within the corridor of Repo and Reverse Repo

Under, tight liquidity conditions, the WACR will be closer/above

the Repo. Under a system flooded with liquidity, the WACR will be
closer to Reverse Repo
 Monetary Transmission Mechanism
• Central Bank sets a lower interest rate target.

• It buys bonds in open market operations and

increases money supply.

• Banks ask for lower interest rates from their

borrowers.

• Investment (and consumption) increases.

 AD AD=Y

Aggregate demand
E2 Ā+c(1-t)Y-bi2

Ā-bi2 Ā+c(1-t)Y-bi1
i2< i1

Ā-bi1 E1

Y1 Y2 Y
Income, output
(a)
Reduction in interest
i rate and subsequent
increase in
Interest rate

i1 E1
investment moves
the aggregate
i2 E2
demand upward.

IS
Y1 Y2 Y
Income, output (b)
DERIVATION OF THE IS CURVE
Reducing Interest Rate in Recessions
 Demand for Money
• What is money? Why does anyone want it?
• Why would anyone want money instead of other interest-
bearing assets/physical assets?

• Demand for money refers to the stock of assets held as cash,

checking accounts, and closely related assets, specifically not
generic wealth or income
• Recall money is the asset used as medium of exchange
 The Demand for Money: Theory
• Keynes’s famous three motives for holding money:

– The transactions motive, which is the demand for money

arising from the use of money in making regular payments

– The precautionary motive, which is the demand for money

to meet unforeseen contingencies

– The speculative motive, which arises from uncertainties

about the money value of other assets that an individual can
Transaction
hold and precautionary motives → mainly discussing M1
Speculative motive → M2, as well as non-money assets
15-76
 Transaction Demand
• Due to lack of synchronization of receipts and disbursements
– You are not likely to get paid at the exact moment you need to make
a payment → keep money on hand to make purchases between pay
periods

• There is a tradeoff between the amount of interest an

individual forgoes by holding money and the costs of holding
very small amount of money
– Benefits of keeping very small amounts of money on hand is
interest earned on money left in the bank
– Cost of keeping very small amounts of money is the cost and
inconvenience of making trips to the bank to withdraw more

15-77
 The Demand for Money: Theory
• The demand for money is the demand for real money balances → people
hold money for its purchasing power
– Two implications:
1. Real money demand is unchanged when the price level increases, and all
real variables, such as the interest rate, real income, and real wealth,
remain unchanged
2. Equivalently, nominal money demand increases in proportion to the
increase in the price level, given the real variables just specified
3. Price elasticity of money demand is 1

An individual is free from money illusion if a change in the level of prices,

holding all real variables constant, leaves the person’s real behavior,
including real money demand, unchanged.
 Transaction Demand
• Suppose the following:
• Alternative #2:
– Y = $1800/month
––Person spends
Person the Ydeposit
could evenly over the amount, and each day take the needed
entire
month, at a rate of $60/day
$60 out of the bank
• Alternative 1:
→ earn interest on money left in the bank over the course of the month
– Person could keep the entire $1800 in
cash•and
Cash
spendbalances
$60/day fall from $1800/30 to zero every day
• Cash balances falls smoothly
• Average balance of
from $1800 to $0 at the end
of the month
• Average balance of

• Forgone interest of
• Forgone interest of
 Average Money Holding
• Let’s presume that an individual receives a payment Y at the beginning of the
month in the saving account (or as bonds)

• Individual engages in n transactions per month to convert bonds into money

• Z is the size of each transaction

• Thus nZ = Y
Amount of cash
held by the public
n =1 n =2 related to number
of transactions.

Average balance held during the month is: Z/2 = Y/2n

15-80
The cost of holding (or not holding) money

• Cost of holding money:

– Interest rate: By holding money you lose nominal
interest rate (note that it is the nominal and not
real interest rate)

• Cost of not holding sufficient money

– You need to go to bank/engage in frequent
transactions to convert bond into money
Minimizing the Cost of Portfolio Managed

• Interest
  rate on bonds is i
• Cost of per transaction of moving bond to money
is tc

• The combined cost of trips plus forgone interest is:

• Individual minimizes the cost.

• To minimize C with respect to n,
 Demand for Real Money Holding
•  
• Put the value of
•

By choosing n to minimize costs and computing the average money

holdings, we get the Baumol-Tobin formula for the demand for money
 Transaction Demand
• The Baumol-Tobin model is a model of the
transaction demand for money
Demand for money:

1) Decreases with the interest rate

2) Increases with the cost of

transactions

3) Increases with income

 The Precautionary Motive
• The Baumol-Tobin model ignored uncertainty
– People are uncertain about the payments they might
want or have to make → there is demand for money
for these uncertain events
• Cab on a rainy day

• The more money a person holds, the less likely

he or she is to incur the costs of illiquidity
• Added consideration is that greater uncertainty about
receipts and expenditures increases the demand for money
– Salaried vs non-salaried person

15-85
 Speculative Demand for Money
• Focuses on the store-of-value function of money →
money in the investment portfolio of an individual
• Wealth held in specific assets → portfolio
– Due to uncertainty, unwise to hold entire portfolio in a single
risky asset → diversify asset holdings
• Money is a safe asset, but gives zero nominal interest
rate.
– Demand for money depends upon the expected yields and
riskiness of the yields on other assets (James Tobin)
Increase in the opportunity cost of holding money lowers money
demand
Increase in the riskiness of the returns on other assets increases
money demand

15-86
 Empirical Estimates
• Empirical work establishes four essential properties of
money demand:
– The demand for money balances responds negatively to the
rate of interest. An increase in interest rates reduces the
demand for money.
– The demand for money increases with the level of real
income.
– The demand for nominal money balance is proportional to the
price level. There is no money illusion; in other words, the
demand for money is a demand for real balances.
– Lagged response: The short-run responsiveness of money
demand to changes in the interest rates and income is
considerably less than the long-run response.
• Lagged response: Cost of adjusting money holding, adjustment in
expectation (that the change in interest rate are not temporary)
15-87
 Policymakers Focusing more on Broad
Money rather than Narrow money
• Innovation in the financial system has made switch
between M1 and M3 has made the demand for M3
more stable
– When money flows between M1 and M3, former changes but
the latter does not change

• The real money demand would negatively

depend on the opportunity cost of holding M3:
the difference between treasury rate and the
deposits constituting M3
 Transaction Velocity of Money
• M VT = PT

• where
• M = Monetary stock (M3)
• P = Price value of a typical transaction
• T = Total number of transactions where goods/services are exchanged for
money
• VT = number of times the currency changes hand during the given period

• Suppose 600 kg of wheat is sold in a given year at Rs 10/kg, the value

transaction (PT) = 6000 /year
• Total money supply (M3) in the economy is 500
• The VT = 12
From Transaction to ‘The Income Velocity’
• The income velocity of money: the number of times the
stock of money is turned over per year in financing the
annual flow of income.

– It is equal to the ratio of nominal GDP to the nominal money stock,

or:

 Or, it can also be interpreted as the ratio of real income to real

balances

15-90
 The Income Velocity
– Demand for real balances is:
® Substituting into equation at the top , velocity can be written
as:

® If elasticity of money demand is 1 (as empirical estimates for

the US shows M2 @ 0.98), then Money demand can be written
as:

® Velocity of money is:

® Since money demand is inversely related to interest rate, higher

the interest rate, lower the money demand, higher the velocity15-91
 The Income Velocity (US)

• Figure shows M2 velocity (left scale) and the Treasury bill interest rate (right
scale)
– Velocity is relatively stable, as left-hand scale is only between 1.5 and 2.2 over a 40
year period
– Velocity has a strong tendency to rise and fall with market interest rates
– Over the last decade M2 velocity has become much less stable than in the past

15-92
 The Quantity Theory (M V = PY)
• The quantity theory of money provides a very
simple way to organize thinking about the
relation between money, prices, and output:

– Equation is the classical quantity equation, linking the

price level and the level of output to the money stock
 If both V and Y are fixed, it follows that the price
level is proportional to the money stock

15-93
 The Quantity Theory
• The classical quantity theory = theory of inflation
– The price level is proportional to the money stock:

– If V is constant, changes in the money supply translate

into proportional changes in nominal GDP
– With the classical case (long-run vertical) supply function,
Y is fixed, and changes in money translate into changes in
the overall price level, P

15-94
 Hyperinflation
• No precise definition, but usually considered when
annual inflation rate reaches 1000 percent.

• People prefer to keep the least possible amount of cash

to avoid inflation tax, shoe-leather costs associated
with reduced money demand are serious during the
hyperinflation

• Businesses need to devote much time and energy to

cash management, menu costs go up
Inflation is
always and
everywhere a
monetary
phenomenon

• Milton
Friedman

But it always
has fiscal
origins

Governments
unable to
collect taxes
starts printing
press
Money Demand and High Inflation
• Would you like to hold your savings in form of
money

• Would you like to put your savings in bank

deposits offering much lower interest rate than
inflation

• Keeping your savings in foreign currency or

commodities might be a better idea
Frontiers of Transaction Methods: Credit cards
• Credit cards are really a loan, not money

• Credit are a method of deferring payment

• When you buy an item using credit card, bank pays the seller the due.
• Later, you repay the bank.

• Though, credit cards are not a form of money, they still impact the demand
for money
– By bunching all payments once per month, credit card reduce the amount of money
people choose to hold.

• Debit cards are part of money supply. Using them is similar to writing a
cheque (the account behind the debit card/cheque is part of money supply)
 Frontiers of Transaction Methods: Bitcoins
• Bitcoin started in 2008, with claimed maximum issuance or the number
of BTC that can ever be as ‘mined’ 21 million units
• The price history of bitcoins (source: Google, November 2020)

Difficult to use such highly volatile ‘asset’ to serve functions of store of

value, and medium of exchange
 How Much Signiorage You Can Have at
Without Intolerable Inflation Rate
• Presume real growth rate = 5.76%
• Acceptable inflation = 4%
• Nominal growth rate (g) = 10%
• Ratio of base money to GDP = 12%

• Safe limit of M0 = 0.10*0.12 = 0.012, or 1.2 % of GDP of the

previous year or 1.2/1.1 = 1.09 % of GDP of the current year

• This presumes that money multiplier remains constant. If

the money multiplier is rising, then less space to create
high powered money