2. 2
In this chapter, look for the answers to
these questions:
What assets are considered “money”? What are
the functions of money? The types of money?
What is the Reserve Bank of India (RBI)?
What role do banks play in the monetary system?
How do banks “create money”?
How does the RBI control the money supply?
3. 3
What Money Is, and Why It’s Important
Without money, trade would require barter,
the exchange of one good or service for another.
Every transaction would require a double
coincidence of wants – the unlikely occurrence
that two people each have a good the other wants.
Most people would have to spend time searching for
others to trade with – a huge waste of resources.
This searching is unnecessary with money,
the set of assets that people regularly use to buy
g&s from other people.
4. 4
The 3 Functions of Money
Medium of exchange: an item buyers give to
sellers when they want to purchase g&s
Unit of account: the yardstick people use to
post prices and record debts
Store of value: an item people can use to
transfer purchasing power from the present to
the future
5. 5
The 2 Kinds of Money
Commodity money:
takes the form of a commodity
with intrinsic value
Examples: gold coins,
cigarettes
Fiat money:
money without intrinsic value,
used as money because of
govt decree
Example: INR
6. 6
The Money Supply
The money supply (or money stock):
the quantity of money available in the economy
What assets should be considered part of the
money supply? Here are two candidates:
• Currency: the paper bills and coins in the
hands of the (non-bank) public
• Demand deposits: balances in bank accounts
that depositors can access on demand by
writing a check
7. 7
MEASURES OF MONEY SUPPLY
IN INDIA
The Reserve Bank of India defines the monetary
aggregates as: Reserve Money (M0): Currency in
circulation + Bankers' deposits with the RBI +
'Other' deposits with the RBI = Net RBI credit to the
Government + RBI credit to the commercial sector
+ RBI's claims on banks + RBI's net foreign assets
+ Government's currency liabilities to the public -
RBI's net non-monetary liabilities.
M1: Currency with the public + Deposit money of
the public (Demand deposits with the banking
system + 'Other' deposits with the RBI).
8. 8
M2: M1 + Savings deposits with Post office
savings banks.
M3: M1+ Time deposits with the banking system
= Net bank credit to the Government + Bank
credit to the commercial sector + Net foreign
exchange assets of the banking sector +
Government's currency liabilities to the public -
Net non-monetary liabilities of the banking
sector (Other than Time Deposits).
M4: M3 + All deposits with post office savings
banks (excluding National Savings Certificates).
9. 9
MANAGEMENT- RBI
CENTRAL BOARD OF DIRECTORS
COMPRISING OF 20 MEMBERS:
• 1 GOVERNOR & 4 DEPUTY GOVERNORS
APPOINTED BY CENTRAL GOVERNMENT
• 4 DIRECTORS NOMINATED BY CENTRAL
GOVERNMENT ONE FROM EACH LOCAL
BOARD
• 10 DIRECTORS NOMINATED BY CENTRAL
GOVERNMENT
• 1 GOVERNMENT OFFICIAL NOMINATED BY
CENTRAL GOVERNMENT
10. 10
LOCAL BOARD
FOR EACH REGIOANAL AREAS OF THE
COUNTRY THERE IS LOCAL BOARD:
• WESTERN – MUMBAI (Head Quarters)
• EASTERN – KOLKOTA
• NORTHERN- NEW DELHI
• SOUTHERN- CHENNAI
Functions: 1)Advising the Central Board
2) Performing other duties delegated by
Central Board
11. 11
D. Subba Rao: Governor
HR Khan: Deputy Governor
Dr. K C Chakrabarty: Deputy Governor
Subir Gokarn: Deputy Governor
Anand Sinha : Deputy Governor (Now
Retired)
12. 12
Newly added member (Sep 2011)
Dipankar Gupta, Sociologist, former Professor,
JNU, Najeeb Jung, Vice Chancellor, Jamia Millia
Islamia, GM Rao, Chairman, GMR Group, Ela
Bhatt, founder and General Secretary of SEWA,
Indira Rajaraman, Professor Emeritus, National
Institute of Public Finance & Policy, Anil
Kakodkar, former Chairman, Atomic Energy
Commission and Kiran Karnik, former Chairman,
NASSCOM.
13. 13
Monetary Measures
On the basis of the current assessment and in line
with policy stance, the Reserve Bank announces
the following policy measures.
Repo Rate
It has been decided to reduce the repo rate under
the liquidity adjustment facility (LAF) by 50 basis
points from 8.5 per cent to 8.0 per cent with
immediate effect.
Reverse Repo Rate
The reverse repo rate under the LAF, determined
with a spread of 100 basis points below the repo
rate, stands adjusted to 7.0 per cent with immediate
effect.
14. 14
Marginal Standing Facility
In order to provide greater liquidity cushion, it has
been decided to:
• raise the borrowing limit of scheduled commercial
banks under the marginal standing facility (MSF)
from 1 per cent to 2 per cent of their net demand
and time liabilities (NDTL) outstanding at the end of
second preceding fortnight with immediate effect.
• Banks can continue to access the MSF even if they
have excess statutory liquidity ratio (SLR) holdings,
as hitherto.
• The MSF rate, determined with a spread of 100
basis points above the repo rate, stands adjusted to
9.0 per cent with immediate effect.
15. 15
Bank Rate
The Bank Rate stands adjusted to 9.0 per cent
with immediate effect.
Cash Reserve Ratio
The cash reserve ratio (CRR) of scheduled
banks has been retained at 4.75 per cent of their
NDTL.
16. 16
Expected Outcomes
The policy actions taken are expected to:
• stabilize growth around its current post-crisis
trend;
• contain risks of inflation and inflation
expectations re-surging; and
• enhance the liquidity cushion available to the
system.
17. 17
Bank Reserves
In a fractional reserve banking system,
banks keep a fraction of deposits as reserves,
and use the rest to make loans.
The RBI establishes reserve requirements,
regulations on the minimum amount of reserves
that banks must hold against deposits.
Banks may hold more than this minimum amount
if they choose.
The reserve ratio, R
= fraction of deposits that banks hold as reserves
= total reserves as a percentage of total deposits
18. 18
Bank T-account
T-account: a simplified accounting statement
that shows a bank’s assets & liabilities.
Example: FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10
Loans $ 90
Deposits $100
Banks’ liabilities include deposits,
assets include loans & reserves.
In this example, notice that R = $10/$100 = 10%.
19. 19
Banks and the Money Supply: An Example
Suppose $100 of currency is in circulation.
To determine banks’ impact on money supply,
we calculate the money supply in 3 different cases:
1. No banking system
2. 100% reserve banking system:
banks hold 100% of deposits as reserves,
make no loans
3. Fractional reserve banking system
20. 20
Banks and the Money Supply: An Example
CASE 1: no banking system
Public holds the $100 as currency.
Money supply = $100.
21. 21CHAPTER 29 THE MONETARY SYSTEM
Banks and the Money Supply: An Example
CASE 2: 100% reserve banking system
Public deposits the $100 at First National Bank (FNB).
FIRST NATIONAL BANK
Assets Liabilities
Reserves $100
Loans $ 0
Deposits $100
FNB holds
100% of
deposit
as reserves:
Money supply
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system,
banks do not affect size of money supply.
22. 22
Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
Money supply = $190 (!!!)
depositors have $100 in deposits,
borrowers have $90 in currency.
FIRST NATIONAL BANK
Assets Liabilities
Reserves $100
Loans $ 0
Deposits $100
Suppose R = 10%. FNB loans all but 10%
of the deposit:
10
90
23. 23
Banks and the Money Supply: An Example
How did the money supply suddenly grow?
When banks make loans, they create money.
The borrower gets
• $90 in currency (an asset counted in the
money supply)
• $90 in new debt (a liability)
CASE 3: fractional reserve banking system
A fractional reserve banking system
creates money, but not wealth.
24. 24
Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
If R = 10% for SNB, it will loan all but 10% of the
deposit.
SECOND NATIONAL BANK
Assets Liabilities
Reserves $ 90
Loans $ 0
Deposits $ 90
Suppose borrower deposits the $90 at Second
National Bank (SNB).
Initially, SNB’s
T-account
looks like this:
9
81
25. 25
Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
If R = 10% for TNB, it will loan all but 10% of the
deposit.
THIRD NATIONAL BANK
Assets Liabilities
Reserves $ 81
Loans $ 0
Deposits $ 81
The borrower deposits the $81 at Third National
Bank (TNB).
Initially, TNB’s
T-account
looks like this:
$ 8.10
$72.90
26. 26
Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
The process continues, and money is created with
each new loan.
Original deposit =
FNB lending =
SNB lending =
TNB lending =...
$ 100.00
$ 90.00
$ 81.00
$ 72.90...
Total money supply = $1000.00
In this
example,
$100 of
reserves
generate
$1000 of
money.
In this
example,
$100 of
reserves
generate
$1000 of
money.
27. 27
Table Sources:
Individual
Bank
Amount Deposited Lent Out Reserves
A 100 80 20
B 80 64 16
C 64 51.20 12.80
D 51.20 40.96 10.24
E 40.96 32.77 8.19
F 32.77 26.21 6.55
G 26.21 20.97 5.24
H 20.97 16.78 4.19
I 16.78 13.42 3.36
J 13.42 10.74 2.68
K 10.74
Total Reserves:
89.26
Total Amount of
Deposits:
Total Amount Lent
Out:
Total Reserves + Last Amount
Deposited:
457.05 357.05 100
28. 28
The Money Multiplier
Money multiplier: the amount of money the
banking system generates with each dollar of
reserves
The money multiplier equals 1/R.
In our example,
R = 10%
money multiplier = 1/R = 10
$100 of reserves creates $1000 of money
29. AA CC TT II VV E LE L EE AA RR NN II NN GG 11::
ExerciseExercise
While cleaning your apartment, you look under the
sofa cushion find a $50 bill (and a half-eaten taco).
You deposit the bill in your checking account.
The Fed’s reserve requirement is 20% of deposits.
29
A. What is the maximum amount that the
money supply could increase?
B. What is the minimum amount that the
money supply could increase?
30. AA CC TT II VV E LE L EE AA RR NN II NN GG 11::
AnswersAnswers
If banks hold no excess reserves, then
money multiplier = 1/R = 1/0.2 = 5
The maximum possible increase in deposits is
5 x $50 = $250
But money supply also includes currency,
which falls by $50.
Hence, max increase in money supply = $200.
30
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
31. AA CC TT II VV E LE L EE AA RR NN II NN GG 11::
AnswersAnswers
Answer: $0
If your bank makes no loans from your deposit,
currency falls by $50, deposits increase by $50,
money supply remains unchanged.
31
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
Answer: $200
B. What is the minimum amount that the
money supply could increase?
32. 32
Origin of RBI
In 1921, 3 Presidency Banks were amalgamated
to form the Imperial Bank of India
Existence in 1st
April,1935 under RBI Act 1934.
Setting up of such institution was based on
recommendation of Hilton Young Commission in
the year 1926.
33. 33
CONSTITUTION OF RBI
CAPITAL – Rs.5 crore
5lakh fully paid up shares of Rs.100 each
Rs. 2.2 lakhs subscribed by the Central
Government
Nationalization of RBI in 1st
January,1949, entire
share capital was acquired by Central
Government
34. 34
FUNCTIONS OF THE RBI
1) MONOPOLY OF NOTE ISSUE- THROUGH
I) ISSUE DEPARTMENT
• II) BANKING DEPARTMENT
• MAINTAINS 18 ISSUE OFFICES; AND NETWORK OF 4301
CURRENCY CHEST AND 4027 SMALL COIN DEPOSITS
• BASIS – I) PROPORTIONAL RESERVE SYSTEM – 40% to
consist of coins, bullions, securities BULLIONS
• - MINIMUM RESERVE SYSTEM- SINCE 1957- Rs.515cr.of
assets- of which- Rs.400cr. In foreign securities and Rs.115cr.
in gold coins & bullions
35. 35
FUNCTIONS CONTD. …
BANKER TO GOVERNMENT
• ISSUE OF NEW LOANS & TREASURY BILLS
• WAYS & MEANS OF ADVANCES
ADVISER TO GOVERNMENT
CONTROLLER OF CREDIT
EXCHANGE CONTROL AUTHORITY
BANKER’S BANK & LENDER OF LAST
RESORT
BANK OF SETTLEMENT & CLEARANCE
PROMOTER OF FINANCIAL SYSTEM
SUPERVISING FUNCTION
36. 36
INSTRUMENTS OF CREDIT
CONTROL
GENERAL OR QUANTITATIVE
• BANK RATE OR THE DISCOUNT RATE POLICY
• OPEN MARKET VARIATIONS
• VARIABLE RESERVE RATIO (CRR, SLR, NLR)
SELECTIVE CREDIT CONTROL
• MINIMUM MARGIN FOR LENDING AGAINST SPECIFIC
SECURITIES
• CEILING ON THE AMOUNT OF CREDIT FOR CERTAIN
PURPOSE (Credit Authorization Scheme)
• DISCRIMINATORY RATES OF INTEREST ON CERTAIN
TYPES OF ADVANCES
MORAL SUASION
37. 37
CRR- CASH RESERVE RATIO-5.5%
The Scheduled commercial banks are
required to maintain a minimum cash
balance with the Reserve Bank at the close
of business on any day.
SLR- STATUTORY LIQUIDITY RATIO-24%
Commercial banks have to maintain liquid
assets in cash, gold and unencumbered
Government securities amounting to not less
than 20% of the total demand and time
liabilities.
39. 39
Monetary Policy
Monetary policy is that part of economic policy in
which central bank controls the cost and supply
of money and credit.
Monetary policy also called as the Reserve Bank
of India’s Credit Policy
40. 40
Objective of Monetary Policy
Monetary policy controls:
Supply of money
Availability of money
Set the rate of interest
Maintain price stability
Prevent inflation
41. 41
Monetary Policy 2010-11
Highlights of first quarter of the RBI's Monetary Policy
for 2010-11
Cash reserve ratio raised by 25 basis points to 6%
Repo rate has been increased by 25 basis points,
5.75%
Reverse repo rate has been increased by 50 basis
points, 4.5%
Bank rate retained at 6%
42. 42
Economic growth projection seen at 8% for
2010-11
Statutory Liquidity Ratio (SLR) has been left
unchanged at 25%
43. 43
Highlights of Mid Quarter of the RBI's
Monetary Policy for 2010-11
The Repo Rate has been increased by 25 basis
point from 5.75% to 6%
The Reverse Repo Rate has been increased by
50 basis point from 4.5% to 5%
However, the CRR, SLR, Bank Rate kept
unchanged.
RBI to closely monitor price situation
Lower policy rates can impair inflationary
expectations
45. 45
The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase
and sale of U.S. government bonds by the Fed.
To increase money supply, Fed buys govt bonds,
paying with new dollars.
…which are deposited in banks, increasing reserves
…which banks use to make loans, causing the
money supply to expand.
To reduce money supply, Fed sells govt bonds,
taking dollars out of circulation, and the process
works in reverse.
46. 46
The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase
and sale of U.S. government bonds by the Fed.
OMOs are easy to conduct, and are the Fed’s
monetary policy tool of choice.
47. 47
The Fed’s 3 Tools of Monetary Control
2. Reserve Requirements (RR).
Affect how much money banks can create by
making loans.
To increase money supply, Fed reduces RR.
Banks make more loans from each dollar of reserves,
which increases money multiplier and money supply.
To reduce money supply, Fed raises RR,
and the process works in reverse.
Fed rarely uses reserve requirements to control
money supply: Frequent changes would disrupt
banking.
48. 48
The Fed’s 3 Tools of Monetary Control
3. The Discount Rate:
the interest rate on loans the Fed makes to banks
When banks are running low on reserves,
they may borrow reserves from the Fed.
To increase money supply,
Fed can lower discount rate, which encourages
banks to borrow more reserves from Fed.
Banks can then make more loans, which increases
the money supply.
To reduce money supply, Fed can raise discount rate.
49. 49
The Fed’s 3 Tools of Monetary Control
3. The Discount Rate:
the interest rate on loans the Fed makes to banks
The Fed often uses discount lending to provide extra
liquidity when financial institutions are in trouble,
such as after the stock market crash of Oct. 1987.
50. 50
The Federal Funds Rate
On any given day, banks with insufficient reserves
can borrow from banks with excess reserves.
The interest rate on these loans is the federal
funds rate.
Many interest rates are highly correlated,
so changes in the fed funds rate cause changes in
other rates and have a big impact in the economy.
The FOMC uses OMOs to target the fed funds
rate.
So fed funds rate policy & monetary policy are
connected.
51. 51
The Federal Funds Rate
To raise fed funds
rate, Fed sells
govt bonds (OMO).
This removes
reserves from the
banking system,
reduces the supply
of fed funds,
causes rff to rise.
rff
F
D1
S2
3.75%
F2
S1
F1
3.50%
The Federal
Funds marketfederal
funds rate
quantity of
federal funds
52. 52
Problems Controlling the Money Supply
If households hold more of their money as
currency, banks have fewer reserves,
make fewer loans, & money supply falls.
If banks hold more reserves than required,
they make fewer loans, & money supply falls.
Yet, Fed can compensate for household
& bank behavior to retain fairly precise control
over the money supply.
53. 53CHAPTER 29 THE MONETARY SYSTEM
Bank Runs and the Money Supply
A run on banks:
When people suspect their banks are in trouble,
they may “run” to the bank to withdraw their funds,
holding more currency and less deposits.
Under fractional-reserve banking, banks don’t
have enough reserves to pay off ALL depositors,
hence banks may have to close.
Also, banks may make fewer loans & hold more
reserves to satisfy depositors.
These events increase R, reverse the process of
money creation, cause money supply to fall.
54. 54
Bank Runs and the Money Supply
During 1929-1933, a wave of bank runs and
bank closings caused money supply to fall 28%.
Many economists believe this contributed to the
severity of the Great Depression.
Bank runs not a problem today due to
federal deposit insurance.
55. 55
CHAPTER SUMMARY
Money includes currency and various types of bank
deposits.
The Federal Reserve is the central bank of the U.S.,
is responsible for regulating the monetary system.
The Fed controls the money supply mainly through
open-market operations. Purchasing govt bonds
increases the money supply, selling govt bonds
decreases it.
In a fractional reserve banking system, banks create
money when they make loans. Bank reserves have
a multiplier effect on the money supply.
Notes de l'éditeur
This chapter is shorter and less difficult than average. Students find most of the material very straightforward.
It contains one analytically challenging topic: the process of money creation in the banking system.
A good idea might be to proceed somewhat quickly through most of the chapter, spending more time on money creation in the banking system, t-accounts, and the money multiplier.
The fourth edition includes a new FYI box on the Federal Funds rate, which I think you and your students will find very useful. I’ve added two slides near the end of this PowerPoint file on the Federal Funds rate: the first one covers the material in the FYI box. The second one uses a supply-demand diagram of the federal funds market to show how the Fed can raise the federal funds rate using open market operations.
As in previous chapters, “g&s” = goods & services.
“Double coincidence of wants” simply means that two people have to want each other’s stuff.
Students find the following example amusing:
I’m an economics professor, but I’m a consumer, too. Suppose I want to go out for a beer. Under a barter system, I would have to search for a bartender that was willing to give me a beer in exchange for a lecture on economics. As you might imagine, I would have to spend a LOT of time searching. (On the plus side, this would prevent me from becoming an alcholic.)
But thanks to money, I can go directly to my favorite pub and get a cold beer; the bartender doesn’t have to want to hear my lecture, he only has to want my money.
Money is a medium of exchange. That just means you use money to buy stuff.
Money is a unit of account. The price or monetary value of virtually everything is measured in the same units – dollars (in the U.S., or substitute your country’s currency if you’re located outside the U.S.). Imagine how hard it would be to plan your budget or comparison shop if sellers each used their own system of measuring prices.
Money is a store of value. Money holds its value over time, so you don’t have to spend it immediately upon receiving it.
Intrinsic value means the commodity would have value even if it weren’t being used as money.
In the film “The Shawshank Redemption,” prisoners use cigarettes as money.
Fiat money is worthless – except as money. Yet, people are happy to accept your dollars (or euros or yen or whatever) because they know that they will be able to spend them elsewhere.
The definition of currency in the textbook does not include “(non-bank)”. I added it to avoid confusion later, when students are asked to think about what happens to the money supply when a consumer decides to deposit a $50 bill into his or her checking account.
Segue from last slide:
The Fed controls the money supply and regulates banks. Banks clearly play an important role in the money supply, because bank deposits are part of the money supply (recall that M1 includes checking account deposits, and M2 also includes savings account deposits).
In the interests of parsimony, I have combined the definitions of “fractional reserve banking system” and “reserves,” as shown in the first bullet point. I believe it is sufficient to convey the meaning of both terms.
Deposits are liabilities to the bank, because they represent the depositors’ claims on the bank.
Loans are an asset for the bank, because they represent the banks’ claims on its borrowers.
Reserves are an asset, because they are funds available to the bank.
The notion that banks create money by making loans is a new and perhaps awkward idea for students. The following slide may help.
Students more easily accept the idea that banks create money when they see that banks do not create wealth.
Reserve requirements were introduced & defined on the slide titled “Bank Reserves,” immediately following “The Structure of the Fed.”
Reserve requirements are not a good tool for monetary policy:
To make the money supply grow over time, the Fed would have to continually reduce reserve requirements. This is neither possible – they cannot be reduced below 0 – nor desirable – if reserves are too low, then banks will have liquidity problems, and bank runs (discussed later in the chapter) might become fashionable again.
To reduce the money supply using reserve requirements, banks wouldn’t be able to make as many loans, which would make the banking industry less profitable, and could cause it to contract.
Why might banks run low on reserves? On any given day, it might turn out that depositors make higher-than-expected withdrawals, or the bank makes more loans than expected.
Indeed, the Fed is a “lender of last resort,” and usually doesn’t make discount loans to banks on demand. The Fed is not in the business of giving banks cheap money to subsidize their profits.
This slide corresponds to a brand new FYI box in the fourth edition of the textbook on the federal funds rate.
This graph is not in the textbook, so it is not supported with material in the study guide or test bank. Therefore, you may wish to omit this slide from your presentation. But I hope you will consider keeping it. It is uses a simple supply-demand diagram to illustrate something described verbally in the text: how the Federal Reserve targets the federal funds rate.
The demand for federal funds comes from banks that find themselves with insufficient reserves, perhaps because they made too many loans or had higher-than-expected withdrawals.
The supply of federal funds comes from banks that find themselves with more reserves than they want, perhaps because they had lower-than-expected withdrawals, or because few customers took out loans.
The federal funds rate adjusts to balance the supply of and demand for federal funds.
The Federal Reserve can use OMOs to target the fed funds rate. Whenever the rate starts to fall below the Fed’s target, the Fed sells government bonds in the open market in order to pull reserves out of the banking system, which raises the rate as shown in this diagram. If the rate rises above the Fed’s target, the Fed buys govt bonds in the open market, injecting reserves into the banking system, and pushing the rate down.
For the Fed, OMOs are quick, easy, and effective, so the Fed can keep the fed funds rate very close to the target.