Unit VII: Central Bank, Money &

Credit
 Money
• It is anything people accept for exchange of goods and
services
• In the past, “barter” system (in absence of money)
• It require a “double coincidence of demand”
• negotiation over the exchange
• It has economic cost of time spent
• Modern Economy
• Paper currency is a means of exchange
• Money possesses general acceptability and has legal power to
discharge debts
 Definitions of Money
• “A commodity which is used to denote anything which is
widely accepted in payment for goods or in discharge of
other business obligations” – Prof. Robertson

• “Money is anything that is generally acceptable as a means

of exchange i.e., for settling debts and at the same time
acts as a measure and as a store of value”- Crowther

• “Money is what money does”- Prof. Walker

 Money Vs Near Money

Money
Near money assets
• currency and Bank • Secure value of money
deposits temporarily and are
convertible into a medium of
• Coins & currency notes exchange in short time
issued by central bank without loss in their face
and cheques of value.
commercial banks are
liquid assets • Example: Time deposits,
bonds, securities,
• Cheques and bank drafts
debentures, bill of exchange,
are almost perfect
treasury bills etc.
substitutes for money
 Commodity Money Vs. Fiat Money
Commodity money
• Money that has intrinsic
value
• Money whose value
comes from a commodity
of which it is made
• Gold, silver, copper, salt,
peppercorns, tea, shells,
alcohol, cigarettes,
cannabis, candy, cocoa
beans, barley, etc.
Fiat money
• Money not backed by a
physical commodity
(currency that a
government has declared
to be legal tender)
• the US has had a Fiat
currency since 1971.
Before that, it could be
converted to gold or silver.
Example—US Dollars,
• Bhutanese Ngultrum
 Functions of
Money

Primary Secondary
Functions Functions

Standard of
Medium of Measure Store of Transfer
Deferred
Exchange of Value Value of Value
Payment

Basis of credit: Credit system depends on money supply

 Demand for Money
• Liquidity Preference
• It shows the amount of money that people want to hold at each
and every interest rate, all other things being unchanged.
• Keynes
• He stated that people’s demand for money does not mean the
actual cash balances people hold, but the amount of cash
balance they want to hold “Liquidity Preference”
• Three motives that influence on individual holding money in cash
• Transaction, Precautionary and Speculative motive.
• Corresponding to each motive is Demand for Money: transaction,
precautionary and speculative.
 Transaction Demand for Money
• To conduct their day to day personal and business transactions
by both household and business enterprises.
• Transaction motive arises due to time gap between receipt of
income and expenditure.
• Spending is done as and when need arises.
• Assuming other factors as given and stable; the transaction
demand for money is an increasing function of money income
and interest inelastic.
• Aggregate transactions demand for money is given by the
function: Mt = f(Y)
 Precautionary Demand for Money
• To meet unforeseen contingencies/events
• keep cash balances besides what is required for transaction
purposes to meet future uncertain emergencies.
• illness, accident, special ceremonial occasions, etc. for households;
• repairs & breakdown of machinery, theft, fire, etc. for business enterprises
• Under normal circumstances and stable market conditions,
precautionary demand for money is income determined and
interest inelastic. Mp = f(Y).
• Therefore, transactions and precautionary demand for money is
affected by the same variable – level of national income.
• Mt + Mp = f (Y)
 Speculative Demand for Money
• To earn profits by “knowing better than the market what the future will
bring”
• It depends on speculators’ expectations regarding the future interest
rate or the price of assets like bonds.
• Eg: Price of bonds to fall, likely to hold more cash as to spend in future
• There is inverse relationship between interest and speculative
demand for money.
• At higher interest rate, small amount of assets chosen by wealth holders in
the money form.
• Speculative demand for money is interest elastic. Ms = f(i)
• Therefore, Total demand for money
• Md = Mt + Mp + Ms
Demand for Money
 Money Supply
• It refers to the total stock of money in the economy at a
particular point of time (quantity of money).

• Keynes defined money supply as currency with public and

demand deposits (saving deposits) with commercial banks.
 Money Supply
• Prof. Friedman defines money supply at any moment of
time as “literally the number of dollars people are carrying
around in their pockets, the number of dollars they have to
their credit at banks or dollars they have to their credit at
banks in the form of demand deposits and also commercial
bank time deposits”.
 Money Supply
• The money in the circulation is the money supply (may be in
the following forms):
• Currency notes and coins
• Demand deposits such as saving banks deposits/current
accounts,
• Other deposits such as time deposits/term deposits deposits
(including recurring deposits)
• Cash in hand and Deposits of banks in other banks/Central Bank
(excluding reserves –CRR & SLR)
 Determinants of money supply
(Controlling Money Supply)

• Determined by the Central Bank and changes in the

economic activity
1. Required Reserve Ratio (fixed by Law)
1. Cash Reserve Ratio (CRR) – Ratio of Cash to Current & Time
Deposit Liabilities – Primary reserve ratio
2. Statutory Liquidity Ratio (SLR) – Secondary reserve ratio
(additional measure). It can be in the form of liquid assets like
Cash, Gold, T-bills, govt. approved securities
 Determinants of money supply

2. The Level of Bank Reserves

Central Bank influences the banks reserves
1. Open market Operation
• Purchase and Sale of govt securities and other types of assets like
bills, securities, bonds
• When Central Banks buys securities, reserve level expands
(Quantitative Easing)
2. Discount Rate Policy/Bank Rate Policy
• Rate at which the commercial bank borrows from the central bank
• It influences the cost and supply of bank credit to commercial banks
• Raising the lending rate, contraction of credit and bank reserves
 Determinants of money supply
3. Public Desire to hold Currency (Cash) and Deposits
• Habit of keeping less cash and more deposits with the banks,
money supply will be large
4. High Powered Money (monetary base/M0)
• Sum of bank reserves and currency (notes & coins) held by the
public
• Basis for the expansion of bank deposits and creation of money
supply
5. Other Factors
• Interest rates, income and changes in business activity
• Affects the behavior of banks and the public
 How do we Measure Money Supply?
• Bhutan’s central bank (RMA) uses following monetary
aggregates
• M0 = Reserve money
• M1 = Narrow money
• M2 = Broad money
M0 (RBI): “High-powered money” or Monetary base
• Reserve money is all cash in the economy which includes:
• Currency with the public
• Cash reserves of the banks held with Central Bank i.e., required
reserves (RR).
• Currently banks are required to keep 10% CRR of their total time and demand
liabilities.
• Cash Reserves of the banks held with themselves i.e., excess reserves
(ER)
• Any other deposits with the central bank- deposits from foreign central
banks, multilateral institutions.

*It consists of Currency (notes & coins) and banks’ deposits at the Central
Bank
 M1: Narrow Money
• Currency outside banks and transferable deposits (current
and saving deposits) held for transaction purposes
• May include foreign currency deposits that are used for domestic
transaction and Traveller’s cheques

• Bank reserves are excluded in M1

• The definition implies that only assets that are directly used in
making payments should be considered.
 M1: Narrow Money
• Currency outside banks and transferable deposits
(comprising of current and saving deposits) held for
transaction purposes.

• OECD: Transferable deposits comprise all deposits that

are (a) exchangeable on demand at par, without penalty or
restriction; (b) freely transferable by cheque or giro-order and
(c) otherwise commonly used to make payments.

• RMA (2015): Demand deposits and quasi money (near

money) are replaced by transferable deposits and other
deposits
 M2: Broad Money

• Includes money and close substitute for money (broader

classification of money)
• M2 = Net foreign Assets (NFA) + Domestic Credit (DC) –
other items net (OINS)
• M2 = M1+ Other deposits
• Other deposits (quasi money) includes time deposits &
foreign currency deposits, CDs, Repo, etc.)
The net foreign asset (NFA) position of a country is the value of the assets that
country owns abroad, minus the value of the domestic assets owned by foreigners.

Repo: is a form of short-term borrowing for dealers in government securities. In the

case of a repo, a dealer sells government securities to investors, usually on an
overnight basis, and buys them back the following day at a slightly higher price.