Money and Financial system

PGP 26 Economic Environment : Sec D and Sec E and

PGP-Finance_03
RAC Chair RAC Area Member RAC Cross-Area Member
Lecture
Prof. Anubha S. Sinha
Prof. Sumit Mitra Prof. Debabrata Chatterjee
Learning objectives
o What is money?
o What are the characteristics of good money?
o Financial institutions and the functions of RBI
o How do RBI ensure the stability of value of money?
o How do banks create money?
o Financial institutions and the functions of RBI?
o What is money supply defined in RBI norms?

27/06/2023 Board Capital and CSR 2

Primitive System: Island Economy

Robinson Crusoe

THINGS GET COMPLICATED AS MORE PEOPLE ARRIVE

 Barter economy

Inputs of land, labour, etc

Households Firms

Consumption of Outputs

THE NEXT STEP IS A MONETISED ECONOMY

 Barter economy

Incomes( rents, wages)

Monetised Inputs of land, labour, etc

economy

Households Firms

Consumption of Outputs

Payment for outputs

THE NEXT STEP IS A FINANCIALIZED ECONOMY

 Economy with
Financial claims Barter economy
Provide Savings

Incomes( rents, wages)

Monetised Inputs of land, labour, etc

economy

Households Firms

Consumption of Outputs

Payment for outputs

Issue Financial claims

Financialized economy and growth
In a two sector economy
Households provide savings to the firms which helps them to grow
In return Firms can issue financial claims : Bonds, Ownership, Board position , share of
distributed profits
Problems
1)Mismatch in requirement: Households have small amount of saving but firms require
huge amounts
2)Liquidity mismatch : Household can ask for money during emergency while firms might
have invested in long term projects
3)Risk appetite: Households wants risk aversion while firms might require this for risky
ventures
WE NEED A BROKER TO DEAL WITH THIS
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 Financial System
Provide Savings Provide Savings
1. MARKETS

Households Firms

2. INSTITUTIONS

Issue Financial claims Issue Financial claims

Motivation: Why we need an integrated financial system
oHouseholds can now channel savings into investment

oGovernments and Firms can borrow and issue financial claims

Additional benefit of financialized system
During a business cycle, An upward increase in AD curve
means more demand for money from households, and
government to spent more and firms to expand or produce
more.

We are in equilibrium: Planned credit demand =50000 crores

:Unplanned credit demand =0

Disequilibrium : Planned credit demand =50000 crores

: Unplanned credit demand =20000 crores

So supply of money has to be taken care by financial

institutions

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Money is what money does!

Functions of Money:
Medium of exchange
Unit of account
Store of value

We need to understand properties of money

Money with certain characteristics should be supplied
by financial institutions for taking care of business
cycle disequilibrium's.
Commodity money vs. fiat money

Earliest form of money was

commodity money like gold/silver
had intrinsic value
Modern money or currency does not
have intrinsic value (coins, notes) but:
was commodity-backed till 1970s
since then is fiat money
has ideal properties
Properties of Ideal or Good Money
Stability of value:
Intrinsic value
Durable
Control over supply leads to stable value
Convenience:
Should be easy to carry and easy to use for small purchases
Technology has led to more convenient forms of money
Coins vs Notes: Intrinsic value
Coin minting: at Mints owned by Govt of India (since
intrinsic value & actual value are almost same)
Note printing: at printing presses owned by RBI (since
Govt can’t be trusted?!)
It costs 50 paise for printing a note of Rs 5, 96 paise for Rs
10, Rs. 1.81 for Rs 50 note, Rs 1.79 for Rs. 100
Source:
http://firstbiz.firstpost.com/economy/why-is-printin
g-a-rs-50-note-costlier-than-a-rs-100-note-30849.ht
ml
Legal Tender

Coin of any denomination not

lower than one rupee is legal
tender for any sum
Half rupee coin is legal tender
for any sum not exceeding ten
rupees
Every banknote issued by
Reserve Bank of India is legal
tender ("I promise to pay the
bearer the sum of Rupees…”)
Credit and Banks

Bank = Banco (Italian for

bench)

Bankruptcy = Banca rotta

(Italian for broken bench)

Credo (origin of the word Credit) is

Latin for “I believe”

15
 Financial
Institutions
Types of Financial
Institutions Commercial
Regulatory
Institutions Institutions

RBI Banks Non-banks

SEBI, IRDA,
Retail banks NBFCs
PFRDA

Wholesale Insurance
banks companies

Cooperative Mutual funds,

banks Pension funds
 Reserve Bank of India

• RBI Act (1934), fully owned by Govt of India

• The Preamble of the Reserve Bank of India describes the basic functions as:
"...to regulate the issue of Bank Notes and keeping of reserves with a view
to securing monetary stability in India and generally to operate the
currency and credit system of the country to its advantage;
to have a modern monetary policy framework to meet the challenge of an
increasingly complex economy, to maintain price stability while keeping in
mind the objective of growth."
• Core Purpose: To foster monetary and financial stability conducive to
sustainable economic growth and to ensure the development of an efficient
and inclusive financial system.
 Main Functions of the RBI
Monetary Authority: Conducts Monetary Policy to maintain price
stability & credit availability
Regulator & Supervisor: Maintain public confidence, protect depositors’
interest & provide cost effective banking services
Manager of Foreign Exchange: Manages foreign exchange to facilitate
trade & maintain orderly conditions in forex market
Issuer of Currency: Ensures adequate supply and in good quality
Developmental Role: To support national objectives
Banker to Government and to Banks
Organizational Structure

Departments such as Monetary Policy, Banking

regulation & supervision, Non-banking regulation &
supervision, Currency management, Foreign exchange,
Economic Research, Statistics etc.
Simplified Balance Sheet of RBI

Liabilities Assets
Currency in circulation (held by Domestic assets (government
public & some by banks) bonds, loans to banks, other
financial institutions)
Reserves Foreign assets
(deposits by banks with the RBI  (foreign government bonds,
CRR of 3% & excess reserves) gold, forex reserves)
Non monetary liabilities (paid up Other assets
capital, surplus, employees PF etc.) (physical assets)

• Is the currency in circulation backed by gold?

• How does RBI decide how much ‘money’ to print?
• Is it a policy decision or a demand decision?
Role of Banks in ‘Creating’ Money

Simplified balance sheet of a commercial bank:

ASSETS LIABILITIES AND CAPITAL

Reserves (cash with RBI) Deposits

Loans Capital
Other Assets Other Liabilities
Role of Banks in ‘Creating’ Money
 Suppose RBI buys bonds worth Rs.1000 from a bond investor
 This is known as an Open Market Operation (OMO)
 Suppose the bond investor deposits the Rs.1000 in Firstbank
 Initially, Firstbank’s balance sheet is:
 Suppose CRR is 10%
FIRSTBANK’S
balance sheet  Firstbank will hold
10% of deposits in
Assets Liabilities
reserves deposits reserve with RBI,
making loans with
Rs.100 Rs.1,000
the rest.
loans Rs.900
Role of Banks in ‘Creating’ Money

 Suppose the borrower deposits the Rs.900 in

Secondbank.
 Initially, Secondbank’s balance sheet is:

SECONDBANK’S • Secondbank will hold

10% in reserves with
balance sheet RBI and loan 90% of
Assets Liabilities this deposit.
reserves Rs.90 deposits
Rs.900
loans Rs.810
Role of Banks in ‘Creating’ Money

 If this Rs.810 is eventually deposited in Thirdbank,

THIRDBANK’S
balance sheet  Then Thirdbank
Assets Liabilities will keep 10% of it
deposits in reserve,
reserves Rs.81 Rs.810
and loan the rest
loans Rs.729 out.
 Finding the total supply of money:
Firstbank deposit = Rs.1000
+ Secondbank deposit = Rs. 900
+ Thirdbank deposit = Rs. 810
+ Fourthbank deposit = Rs. 729
+ subsequent deposits…

Total money supply = 1000+ (1-crr)1000 + (1-crr)21000 +… = (1/crr ) 1000

where crr = cash reserve ratio
In our example, crr = 0.1, so M = Rs.10,000
Rs. 1000 liquidity injection led to new money supply of Rs. 10,000!
(1/crr) is the money multiplier. Not to be confused
with Keynesian (expenditure) multiplier
 Money Supply
• Currency is money
• ‘Bank money’ can be used as medium of exchange, store of value, and is therefore money (demand
deposits)

• Money supply = currency + demand deposits with banks

• Money Supply (M ) = C + D

• Specifically,
 M1 = Currency with the public + Demand deposits with the banking system + ‘Other’ deposits with the
RBI.
 M2 = M1 + Savings deposits of post office savings banks
 M3 = M1+ Time deposits with the banking system
 M4 =M3 + All deposits with post office savings banks (excluding National Savings Certificates).

M1 and M2 are called narrow money whereas M3 and M4 are called Broad Money.
Finding the total supply of money:

Money Supply (M ) = C + D
In this example we assumed there was no change in C as all bank
customers deposited their funds with banks
Therefore to know money supply, we need to track D i.e. the deposit
creation (or credit creation) by banks