CH 8 - Money Market
CH 8 - Money Market
CH 8 - Money Market
MONEY MARKET
LEARNING OUTCOMES
CHAPTER OVERVIEW
Money Market
Post-Keynesian
The Theories of Developments
Functions
Demand Demand for in the Theory of
of Money
for Money Money Demand for
Money
1.1 INTRODUCTION
Money may make the world go around, it plays an essential role in causing the things in life
to work as they should; to underlie the fulfilment of the needs of human existence. And most
people in the world probably have handled money, many of them on a daily basis. But despite
its familiarity, probably few people could tell you exactly what money is, or how it works.
In short, money can be anything that can serve as a
(1) store of value, which means people can save it and use it later—smoothing their
purchases over time;
(2) unit of account, that is, provide a common base for prices; or
(3) medium of exchange, something that people can use to buy and sell from one another.
Perhaps the easiest way to think about the role of money is to consider what would change if
we did not have it.
If there were no money, we would be reduced to a barter economy. Every item someone
wanted to purchase would have to be exchanged for something that person could provide.
For example, a person who specialises in fixing cars and needed to trade for food would have
to find a farmer with a broken car. But what if the farmer did not have anything that needed
to be fixed? Or what if a farmer could only give the mechanic more eggs than the mechanic
could reasonably use? Having to find specific people to trade with makes it very difficult to
specialise. People might starve before they were able to find the right person with whom to
barter.
But with money, you don’t need to find a particular person. You just need a market in which
to sell your goods or services. In that market, you don’t barter for individual goods. Instead
you exchange your goods or services for a common medium of exchange—that is, money.
You can then use that money to buy what you need from others who also accept the same
medium of exchange. As people become more specialised, it is easier to produce more, which
leads to more demand for transactions and, hence, more demand for money.
To put it a different way, money is something that holds its value over time, can be easily
translated into prices, and is widely accepted. Many different things have been used as money
over the years—among them, cowry shells, barley, peppercorns, gold, and silver.
Fiat Money
Until relatively recently, gold and silver were the main currency people used. Gold and silver
are heavy, though, and over time, instead of carrying the actual metal around and exchanging
it for goods, people found it more convenient to deposit precious metals at banks and buy
and sell using a note that claimed ownership of the gold or silver deposits. Anyone who
wanted to could go to the bank and get the precious metal that backs the note. Eventually,
the paper claim on the precious metal was delinked from the metal. When that link was
broken, fiat money was born. Fiat money is materially worthless, but has value simply because
a nation collectively agrees to ascribe a value to it. In short, money works because people
believe that it will. As the means of exchange evolved, so did its sourc e—from individuals in
barter, to some sort of collective acceptance when money was barley or shells, to governments
in more recent times.
There are some general characteristics that money should possess in order to make it serve
its functions as money. Money should be:
• generally acceptable
• durable or long-lasting
• effortlessly recognizable.
• divisible into smaller parts in usable quantities or fractions without losing value
How money is measured
In official statistics, the amount of money in an economy is generally measured through what
is called broad money, which encompasses everything that providers a store of value and
liquidity. Liquidity refers to the extent to which financial assets can be sold at close to full
market value at short notice. That is, they can easily be converted into another form of money,
such as cash. Although currency and transferable deposits (narrow money) are included by
all countries in broad money, there are other components that may also provide sufficient
store of value and liquidity to count as broad money. Among the things the IMF (2000) says
can be counted as broad money are the following:
National currencies (generally issued by the central government).
Transferable deposits, which include demand deposits (transferable by check or money order),
bank checks (if used as a medium of exchange), travelers checks (if used for transactions with
residents), and deposits otherwise commonly used to make payments (such as some Foreign-
Currency deposits).
Other deposits, such as nontransferable savings deposits., term deposits (funds left on deposit
for a fixed period of time), or repurchase agreements (in which one party sells a security and
agrees to buy it back at a fixed price).
Securities other than shares of stock. Such as tradable certificates of deposit and commercial
paper (which is essentially a corporate IOU).
Source : IMF
its purchasing power. The demand for money is a demand for real balances. In other words,
people demand money because they wish to have command over real goods and services
with the use of money. Demand for money is actually demand for liquidity and demand to
store value. The demand for money is a decision about how much of one’s given stock of
wealth should be held in the form of money rather than as other assets such as bonds.
Although it gives little or no return, individuals, households as well as firms hold money
because it is liquid and offers the most convenient way to accomplish their day to day
transactions.
Demand for money has an important role in the determination of interest, prices and income
in an economy. Understanding money demand and how various factors affect that demand
is the basic requirement in setting a target for the monetary authority.
Before we go into the theories of demand for money, we shall have a quick look at some
important variables on which demand for money depends on. The quantity of nominal money
or how much money people would like to hold in liquid form depends on many factors, such
as income, general level of prices, rate of interest, real GDP, and the degree of financial
innovation etc. Higher the income of individuals, higher the expenditure; richer people hold
more money to finance their expenditure. The quantity which people desire to hold is directly
proportional to the prevailing price level; higher the prices, higher should be the holding of
money. As mentioned above, one may hold his wealth in any form other than money, say as
an interest yielding asset. It follows that the opportunity cost of holding money is the interest
rate a person could earn on other assets. Therefore, higher the interest rate, higher would be
opportunity cost of holding cash and lower the demand for money. Innovations such as
internet banking, application based transfers and automated teller machines reduce the need
for holding liquid money. Just as households do, firms also hold money essentially for the
same basic reasons.
The total supply of money in the community consists of the quantity of actual money (M) and
its velocity of circulation (V). Velocity of money in circulation (V) and the velocity of credit
money (V') remain constant. T is a function of national income. Since full employment prevails,
the volume of transactions T is fixed in the short run. Briefly put, the total volume of
transactions (T) multiplied by the price level (P) represents the demand for money. The
demand for money (PT) is equal to the supply of money (MV + M'V)'. In any given period, the
total value of transactions made is equal to PT and the value of money flow is equal to MV +
M'V'.
There is an aggregate demand for money for transaction purposes and more the number of
transactions people want, greater will be the demand for money. The total volume of
transactions multiplied by the price level (PT) represents the demand for money.
1. enabling the possibility of split-up of sale and purchase to two different points of time
rather than being simultaneous, and
Where
The term ‘k’ in the above equation is called ‘Cambridge k’ is a parameter reflecting economic
structure and monetary habits, namely the ratio of total transactions to income and the ratio
of desired money balances to total transactions. The equation above explains that the demand
for money (M) equals k proportion of the total money income.
Thus we see that the neoclassical theory changed the focus of the quantity theory of money
to money demand and hypothesized that demand for money is a function of only money
income. Both these versions are chiefly concerned with money as a means of transactions or
exchange, and therefore, they present models of the transaction demand for money.
According to Keynes, people hold money (M) in cash for three motives:
(i) Transactions motive,
(ii) Precautionary motive, and
Lr = kY
Where
Lr, is the transactions demand for money,
k is the ratio of earnings which is kept for transactions purposes
Y is the earnings.
Keynes considered the aggregate demand for money for transaction purposes as the sum of
individual demand and therefore, the aggregate transaction demand for money is a fu nction
of national income.
motive depends on the size of income, prevailing economic as well as political conditions and
personal characteristics of the individual such as optimism/ pessimism, farsightedness etc.
Keynes regarded the precautionary balances just as balances under transactions motive as
income elastic and by itself not very sensitive to rate of interest.
(c) The Speculative Demand for Money
The speculative motive reflects people’s desire to hold cash in order to be equipped to exploit
any attractive investment opportunity requiring cash expenditure. According to Keynes,
people demand to hold money balances to take advantage of the future changes in the rate
of interest, which is the same as future changes in bond prices. It is implicit in Keynes theory,
that the ‘rate of interest’, i, is really the return on bonds. Keynes assumed that that the
expected return on money is zero, while the expected returns on bonds are of two types,
namely:
(i) the interest payment
(ii) the expected rate of capital gain.
The market value of bonds and the market rate of interest are inversely related. A rise in the
market rate of interest leads to a decrease in the market value of the bond, and vice versa.
Investors have a relatively fixed conception of the ’normal’ or ‘critical’ interest rate and
compare the current rate of interest with such ‘normal’ or ‘critical’ rate of interest.
If wealth-holders consider that the current rate of interest is high compared to the ‘normal or
critical rate of interest’, they expect a fall in the interest rate (rise in bond prices). At the high
current rate of interest, they will convert their cash balances into bonds because:
(i) they can earn high rate of return on bonds
(ii) they expect capital gains resulting from a rise in bond prices consequent upon an
expected fall in the market rate of interest in future.
Conversely, if the wealth-holders consider the current interest rate as low, compared to the
‘normal or critical rate of interest’, i.e., if they expect the rate of interest to rise in future (fall
in bond prices), they would have an incentive to hold their wealth in the form of liquid cash
rather than bonds because:
(i) the loss suffered by way of interest income forgone is small,
(ii) they can avoid the capital losses that would result from the anticipated increase in
interest rates, and
(iii) the return on money balances will be greater than the return on alternative assets
(iv) If the interest rate does increase in future, the bond prices will fall and the idle cash
balances held can be used to buy bonds at lower price and can thereby make a capital-
gain.
Summing up, so long as the current rate of interest is higher than the critical rate of interest,
a typical wealth-holder would hold in his asset portfolio only government bonds, and if the
current rate of interest is lower than the critical rate of interest, his asset portfolio would
consist wholly of cash. When the current rate of interest is equal to the critical rate of interest,
a wealth-holder is indifferent to holding either cash or bonds. The inference from the above
is that the speculative demand for money and interest are inversely related.
The discontinuous portfolio decision of a typical individual investor is shown in the figure
above. When the current rate of interest rn is higher than the critical rate of interest rc, the
entire wealth is held by the individual wealth-holder in the form of government bonds. If the
rate of interest falls below the critical rate of interest rc, the individual will hold his entire
wealth in the form of speculative cash balances.
When we go from the individual speculative demand for money to the aggregate speculative
demand for money, the discontinuity of the individual wealth-holder's demand curve for the
speculative cash balances disappears and we obtain a continuous downward sloping demand
function showing the inverse relationship between the current rate of interest and the
speculative demand for money as shown in figure below:
Figure: 2.1.2
Aggregate Speculative Demand for Money
According to Keynes, higher the rates of interest, lower the speculative demand for money,
and lower the rate of interest, higher the speculative demand for money.
The concept of Liquidity Trap
Liquidity trap is a situation when expansionary monetary policy (increase in money supply)
does not increase the interest rate, income and hence does not stimulate economic growth.
Liquidity trap is the extreme effect of monetary policy. It is a situation in which the general
public is prepared to hold on to whatever amount of money is supplied, at a given rate of
interest. They do so because of the fear of adverse events like deflation, war. In that case, a
monetary policy carried out through open market operations has no effect on either the
interest rate, or the level of income. In a liquidity trap, the monetary policy is powerless to
affect the interest rate.
There is a liquidity trap at short term zero percent interest rate. When interest rate is zero,
public would not want to hold any bond, since money, which also pays zero percent interest,
has the advantage of being usable in transactions.
In other words, investors would maintain cash savings rather than hold bonds. The speculative
demand becomes perfectly elastic with respect to interest rate and the speculative money
demand curve becomes parallel to the X axis. This situation is called a ‘Liquidity trap’.
In such a situation, the monetary authority is unable to stimulate the economy with monetary
policy. Since the opportunity cost of holding money is zero, even if the monetary authority
increases money supply to stimulate the economy, people would prefer to hoard money.
Consequently, excess funds may not be converted into new investment. The liquidity trap is
synonymous with ineffective monetary policy.
The Bank of Japan’s experience is a real-life example of the Keynesian economic theory of a
liquidity trap, in which money printed by a central bank is hoarded in anticipation of further
deflation rather than invested. Japan’s 10-year yield dropped to a record 0.2 percent.
Baumol put forward a new approach to demand for money which explains the transaction
demand for money from the viewpoint of the inventory management. Baumol asserts that
individuals hold money (inventory of money) for the transaction purposes.
According to him, individuals have to keep optimum inventory of money for their day to day
transaction purposes. They also incur cost when they hold inventories of money and the cost
forgone is the interest rate which they could have earned if they had kept their wealth in
saving deposits or fixed deposits or invested in bonds or shares. This forgone cost is also
called opportunity cost. Money that people hold in the form of currency and demand deposits
which are very safe and riskless but pays no interest. While bonds or shares provide returns
(interest) but are risky and may also involve capital loss if people invest in them.
But saving deposits in banks is quite safe and risk free but also gives some interest. So, Baumol
questions why people hold money in the form of currency or cash or demand deposits instead
of saving deposits which are quite safe and risk free and also earn some interest as well.
According to him, it is for convenience and capability of it being easily used for transactions
purposes. Baumol and Tobin proclaim that transactions demand for money depends on the
rate of interest.
As interest rates on savings deposits go up people will hold less money in the form of currency
or cash or demand deposits and vice versa. So, individuals compare the costs and benefits of
funds in the form of money with no interest with the money in the form of savings deposits
with some interest. According to Baumol, the cost forgone when people hold money is the
opportunity cost of these funds.
Baumol has proved that the average amount of cash withdrawal which minimises cost is given
by –
C = √2bY/r
This means that the average amount of cash withdrawal which minimises cost is the square
root of the two times broker’s fee multiplied by the size of an individual's income and divided
by the interest rate. This is also called Square Root Rule.
The inventory-theoretic approach also suggests that the demand for money and bonds
depend on the cost of making a transfer between money and bonds e.g. the brokerage fee .
An increase in the brokerage fee raises the marginal cost of bond market transactions and
consequently lowers the number of such transactions. The increase in the brokerage fee raises
the transactions demand for money and lowers the average bond holding over the period.
This result follows because an increase in the brokerage fee makes it more costly to switch
funds temporarily into bond holdings. An individual combines his asset portfolio of cash and
bond in such proportions that his overall cost of holding the assets is minimised.
According to Tobin, an individual's behaviour shows risk aversion, which means they prefer
less risk to more risk at a given rate of return.
If an individual chooses to hold a greater proportion of risky assets such as bonds or shares
in his portfolio, then he will be earning a higher average return but will bear a higher degree
of risk. Tobin argues that a risk averter will not choose such a portfolio with all risky bonds or
a greater proportion of them.
In the other case, an individual who, in his portfolio of wealth, holds only safe and riskless
assets such as money in form of cash or demand deposits, he will be taking almost zero risk
but will also be getting no return. Therefore, people prefer a mixed or diversified portfolio of
money, bonds and shares, with each person opting for a little different balance between risk
and return.
Tobin’s Liquidity Preference Function
Tobin derived his liquidity preference function showing the relationship between rate of
interest and demand for money. He argues that with the increase in the rate of return on
bonds, individuals will be attracted to hold a greater proportion of their wealth in bonds and
less in the form of ready money.
At a higher rate of interest, the demand for holding money will be less and people will hold
more bonds in their portfolio and vice versa.
In Tobin’s portfolio approach demand function for money as an asset slopes downwards,
where horizontal axis shows the demand for money and vertical axis shows the rate of interest.
The downward sloping liquidity preference function curve shows that the asset demand for
money in the portfolio increases as the rate of interest on bonds falls. In this way Tobin derives
the aggregate liquidity preference curve by determining the effects of changes in the interest
rate on the asset demand for money in the portfolio of peoples.
Tobin’s liquidity preference theory has been found to be true by the empirical studies
conducted to measure interest elasticity of the demand for money as an asset.
1.5 CONCLUSION
We have discussed the important theories pertaining to demand for money. All the theories
have provided significant insights into the concept of demand for money. While the
transactions version of Fisher focused on the supply of money as determining prices, the cash
balance approach of the Cambridge University economists established the formal
relationship between demand for real money and the real income. Keynes developed
the money demand theory on the basis of explicit motives for holding money and
formally introduced the interest rate as an additional explanatory variable that
determines the demand for real balances. The post-Keynesian economists developed a
number of models to provide alternative explanations to confirm the formulation relating real
money balances with real income and interest rates. However, we find that all these theorie s
establish a positive relation of demand for money to real income and an inverse relation to
the rate of return on earning assets, i.e. the interest rate. However, the propositions in these
theories need to be supported by empirical evidence. As countries differ in respect of various
determinants of demand for money, we cannot expect any uniform pattern of behaviour.
Broadly speaking, real income, interest rates and expectations in respect to inflation are
significant predictors of demand for money.
SUMMARY
Money refers to assets which are commonly used and accepted as a means of payment
or as a medium of exchange or for transferring purchasing power.
Money is totally liquid, has generalized purchasing power and is generally acceptable
in settlement of all transactions and in discharge of other kinds of business obligations
including future payments.
The functions of money are: acting as a medium of exchange to facilitate easy
exchanges of goods and services, providing a ‘common measure of value’ or ‘common
denominator of value’, serving as a unit or standard of deferred payments and
facilitating storing of value both as a temporary abode of purchasing power and as a
permanent store of value.
Money should be generally acceptable, durable, difficult to counterfeit, relatively
scarce, easily transported, divisible without losing value and effortlessly recognizable.
The demand for money is derived demand and is a decision about how much of one’s
given stock of wealth should be held in the form of money rather than as other assets
such as bonds.
Both versions of the theory of money, namely, the classical approach and the
neoclassical approach demonstrate that there is strong relationship between money
and price level and the quantity of money is the main determinant of the price level or
the value of money.
Keynes’ theory of demand for money is known as the ‘liquidity preference theory’.
‘Liquidity preference’, is a term that was coined by John Maynard Keynes in his
masterpiece ‘The General Theory of Employment, Interest and Money’ (1936).
According to Keynes, people hold money (M) in cash for three motives: the
transactions, precautionary and speculative motives.
The transaction motive for holding cash is directly related to the level of income and
relates to ‘the need for cash for the current transactions for personal and business
exchange.’
The amount of money demanded under the precautionary motive is to meet
unforeseen and unpredictable contingencies involving money payments and depends
on the size of the income, prevailing economic as well as political conditions and
personal characteristics of the individual such as optimism/ pessimism, farsightedness
etc.
The speculative motive reflects people’s desire to hold cash in order to be equipped
to exploit any attractive investment opportunity requiring cash expenditure. The
speculative demand for money and interest are inversely related.
So long as the current rate of interest is higher than the critical rate of interest (rc), a
typical wealth-holder would hold in his asset portfolio only government bonds while if
the current rate of interest is lower than the critical rate of interest, his asset portfolio
would consist wholly of cash.
Liquidity trap is a situation where the desire to hold bonds is very low and approaches
zero, and the demand to hold money in liquid form as an alternative approaches
infinity. People expect a rise in interest rate and the consequent fall in bond prices and
the resulting capital loss. The speculative demand becomes perfectly elastic with
respect to interest rate and the speculative money demand curve becomes parallel to
the X axis.
Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction
demand for ‘real cash balance’, known as Inventory Theoretic Approach, in which
money is essentially viewed as an inventory held for transaction purposes.
People hold an optimum combination of bonds and cash balance, i.e., an amount that
minimizes the opportunity cost.
The optimal average money holding is: a positive function of income Y, a positive
function of the price level P, a positive function of transactions costs c, and a negative
function of the nominal interest rate i.
Milton Friedman (1956) extending Keynes’ speculative money demand within the
framework of asset price theory holds that demand for money is affected by the same
factors as demand for any other asset, namely, permanent income and relative returns
on assets.
The nominal demand for money is positively related to the price level, P; rises if bonds
and stock returns, r b and re, respectively decline and vice versa; is influenced by
inflation; and is a function of total wealth
The Demand for Money as Behaviour toward ‘aversion to risk’ propounded by Tobin
states that money is a safe asset but an investor will be willing to exercise a trade-off
and sacrifice to some extent, the higher return from bonds for a reduction in risk
4. Higher the ______________, higher would be ________________of holding cash and lower will
be the ______________________
(a) money’s role in acting as a store of value and therefore, demand for money is for
storing value temporarily.
(b) money as a means of exchange and therefore demand for money is termed as
for liquidity preference
(c) money as a means of transactions and therefore, demand for money is only
transaction demand for money.
(b) explains the positive relationship between money demand and the interest rate.
(c) explains the positive relationship between money demand and general price level
(d) explains the nature of expectations of people with respect to interest rates and
bond prices
13. According to Baumol and Tobin’s approach to demand for money, t he optimal average
money holding is:
ANSWERS
1. (a) 2. (c) 3. (a) 4. (d) 5. (d) 6 (a)
LEARNING OUTCOMES
UNIT OVERVIEW
Money Market
The concept of
Money Supply
2.1 INTRODUCTION
In the previous unit, we discussed the theories related to the demand for money. Money as a
means of payment and thus a lubricant that facilitates exchange. Irrespective of the form of
money, in any economy, money performs three primary functions – a medium of exchange, a
unit of account, and a store of value. Money as a medium of exchange may be used for any
transactions wherein goods or services are purchased or sold. Money as a unit of account can
be used to value goods or services and express it in monetary terms. Money can also be stored
or conserved for future purposes.
In the real world, however, money provides monetary services along with tangible
remuneration. It is for this reason that money must have a relationship with the activities that
economic entities pursue. Money can, therefore, be defined for policy purposes as a set of
liquid financial assets, the variation in the stock of which could impact aggregate economic
activity.
Economic stability requires that the supply of money at any time should to be maintained at
an optimum level. A pre-requisite for achieving this is to accurately estimate the stock of
money supply on a regular basis and appropriately regulate it in accordance with the
monetary requirements of the country. In this unit, we shall look into various aspects related
to the supply of money.
Money Supply on December 30 th, 2022
Item Outstanding as on
2022 2022
March 31 December 30
1 2 3
M3 (In Crores) 2,04,93,729 2,18,59.358
Components (i+ii+iii+iv)
i) Currency with the Public 30,35,689 31,22,019
ii) Demand deposits with Banks 22,12,992 23,41,912
iii) Time Deposits with Banks 1,51,86,605 1,63,32,494
iv) ‘Other’ Deposits with Reserve Bank 58,444 62,932
Source (i+ii+iii+iv – v)
i) Net Bank Credit to Government Sector (a+b) 64,77,629 65,65,472
(a) Reserve Bank 14,50,596 11,70,253
Money either has intrinsic value or represents title to commodities that have intrinsic value or
title to other debt instruments. In modern economies, the currency is a form of money that is
issued exclusively by the sovereign (or a central bank as its representative) and is legal tender.
Paper currency is such a representative money, and it is essentially a debt instrument.
It is a liability of the issuing central bank (and sovereign) and an asset of the holding public.
The central banks of all countries are empowered to issue currency and, therefore, the central
bank is the primary source of money supply in all countries. In effect, high powered money
issued by monetary authorities is the source of all other forms of money. The currency issued
by the central bank is ‘fiat money’ and is backed by supporting reserves and its value is
guaranteed by the government.
The currency issued by the central bank is, in fact, a liability of the central bank and the
government. Therefore, in principle, it must be backed by an equal value of assets mainly
consisting of gold and foreign exchange reserves. In practice, however, most countries have
adopted a ‘minimum reserve system’ wherein the central bank is empowered to issue currency
to any extent by keeping only a certain minimum reserve of gold and foreign securities.
The second major source of money supply is the banking system of the country. The total
supply of money in the economy is also determined by the extent of credit created by the
commercial banks in the country. Banks create money supply in the process of borrowing and
lending transactions with the public. Money so created by the commercial banks is called
'credit money’. The high-powered money and the credit money broadly constitute the most
common measure of money supply, or the total money stock of a country. (For a brief note
on the process of creation of credit money, refer to Box 1, end of this chapter).
With the developments in the economy and the evolution of the payments system, the form
and functions of money has changed over time, and it will continue to influence the future
course of currency. The concept of money has experienced evolution from Commodity to
Metallic Currency to Paper Currency to Digital Currency. The changing features of money a re
defining new financial landscape of the economy. Further, with the advent of cutting-edge
technologies, digitalization of money is the next milestone in the monetary history.
Advancement in technology has made it possible for the development of new form of money
viz. Central Bank Digital Currencies (CBDCs).
Recent innovations in technology-based payments solutions have led central banks around
the globe to explore the potential benefits and risks of issuing a CBDC so as to maintain the
continuum with the current trend in innovations. RBI has also been exploring the pros and
cons of introduction of CBDCs for some time and is currently engaged in working towards a
phased implementation strategy, going step by step through various stages of pilots followed
by the final launch, and simultaneously examining use cases for the issuance of its own CBDC
(Digital Rupee (e₹)), with minimal or no disruption to the financial system. Currently, we are
at the forefront of a watershed movement in the evolution of currency that will decisively
change the very nature of money and its functions.
Reserve Bank broadly defines CBDC as the legal tender issued by a central bank in a digital
form. It is akin to sovereign paper currency but takes a different form, exchangeable at par
with the existing currency and shall be accepted as a medium of payment, legal tender and a
safe store of value. CBDCs would appear as liability on a central bank’s balance sheet.
The Crypto currencies face significant legislative uncertainties and are not legally recognized
in India as currency. Hence, these are not categorized as money. In a massive development
for crypto traders in India, the Reserve Bank of India (RBI) has said that banks or other financial
entities cannot cite RBI’s 2018 order that barred them from dealing with virtual
cryptocurrencies.
measures are compiled and published by the RBI. Money supply will change if the magnitude
of any of its constituents changes.
In this unit, we shall be concentrating on the Indian case only and in the following discussion,
we shall focus on the alternative measures of money supply prepared and published
periodically by the Reserve Bank of India.
Since July 1935, the Reserve Bank of India has been compiling and disseminating monetary
statistics. Till 1967-68, the RBI used to publish only a single ‘narrow measure of money supply’
(M1) defined as the sum of currency and demand deposits held by the public. From 1967-68,
a 'broader' measure of money supply, called 'aggregate monetary resources' (AMR) was
additionally published by the RBI. From April 1977, following the recommendations of the
Second Working Group on Money Supply (SWG), the RBI has been publishing data on four
alternative measures of money supply denoted by M1, M2, M3 and M4 besides the reserve
money. The respective empirical definitions of these measures are given below:
M1 = Currency notes and coins with the people + demand deposits with the
banking system (Current and Saving deposit accounts) + other
deposits with the RBI.
M2 = M1 + savings deposits with post office savings banks.
M3 = M1 + time deposits with the banking system.
M4 = M3 + total deposits with the Post Office Savings Organization
(excluding National Savings Certificates).
M = m X MB
Where M is the money supply, m is the money multiplier and MB is the monetary base or
high-powered money. From the above equation, we can derive the money multiplier (m) as
Money supply
Money Multiplier (m)= …
Monetary base
Money multiplier m is defined as a ratio that relates the changes in the money supply to a
given change in the monetary base. It is the ratio of the stock of money to the stock of high -
powered money.
For instance, if there is an injection of Rs.100 Cr through an open market operation by the
central bank of the country and if it leads to an increment of Rs.500 Cr. of final money supply,
then the money multiplier is said to be 5. Hence, the multiplier indicates the change in
monetary base which is transformed into money supply.
The multiplier indicates what multiple of the monetary base is transformed into money supply.
In other words, money and high-powered money are related by the money multiplier. We
make two simplifying assumptions as follows;
● Banks never hold excess reserves.
● Individuals and non-bank corporations never hold currency.
What determines the size of the money multiplier? The money multiplier is the reciprocal of
the reserve ratio. Deposits, unlike currency held by people, keep only a fraction of the high -
powered money in reserves and the rest is lent out and culminate in money creation. If R is
the reserve ratio in a country for all commercial banks, then each unit of (say Rupee) money
reserves generates 1/R money.
1
Therefore, for any value of R, the Money Multiplier is
𝑅
For example, if R =10%, the value of money multiplier will be 10. If the reserve ratio is only 5
%, then money multiplier is 20. Thus, the higher the reserve ratio, the less of each deposit
banks loan out, and the smaller the money multiplier.
If some portion of the increase in high-powered money finds its way into currency, this portion
does not undergo multiple deposit expansion. The size of the money multiplier is reduced
when funds are held as cash rather than as demand deposits. In other words, as a rule, an
increase in the monetary base that goes into currency is not multiplied, whereas an increase
in monetary base that goes into supporting deposits is multiplied.
expansions of deposits because the same level of reserves can now support more deposits
and the money supply will increase . To sum up, smaller the reserve ratio larger will be the
money multiplier.
In actual practice, however, the commercial banks keep only the required fraction of their total
deposits in the form of cash reserves. However, for the commercial banking system as a whole,
the actual reserves ratio may be greater than the required reserve ratio since the banks keep
a higher than the statutorily required percentage of their deposits in the form of cash reserves
as a buffer against unexpected events requiring cash.
The excess reserves (ER) which are funds that a bank keeps back beyond what is required by
regulation form a very important determinant of money supply. ‘Excess reserves’ are the
difference between total reserves (TR) and required reserves (RR). Therefore, ER=TR -RR. If
total reserves are Rs 800 billion, whereas the required reserves are Rs 600billion, then the
excess reserves are Rs 200 billion.
We know that the cost to a bank while holding excess reserves is in terms of its opportunity
cost, i.e. the interest that could have been earned on loans or securities if the bank had chosen
to invest in them instead of excess reserves. If interest rate increases, it means that the
opportunity cost of holding excess reserves rises because the banks have to sacrifice possible
higher earnings and hence the desired ratio of excess reserves to deposits falls. Conversely, a
decrease in interest rate will reduce the opportunity cost of excess reserves, and excess
reserves will rise. Therefore, we conclude that the banking system's excess reserves ratio r is
negatively related to the market interest rate .
If banks fear that deposit outflows are likely to increase (that is, if expected deposit outflows
increase), they will want more assurance against this possibility and will increase the excess
reserves ratio. Conversely, a decline in expected deposit outflows will reduce the benefit of
holding excess reserves and excess reserves will fall.
As we know, money is mostly held in the form of deposits with commercial banks. Therefore,
money supply may become subject to ‘shocks’ on account of behaviour of commercial banks
which may present variations overtime either cyclically and more permanently. For instance,
in times of financial crises, banks may be unwilling to lend to the small and medium scale
industries who may become credit constrained facing a higher risk premia on their
borrowings. The rising interest rates on bank credit to the commercial sector reflecting higher
risk premia can co-exist with the lowering of policy rates by the central bank. The lower credit
demand can lead to a sharp deceleration in monetary growth at a time when the central bank
pursues an easy monetary policy. (Refer Box *1 below).
r = 10%= 0.10
c = C/D = 400 billion/800 billion = 0.5 or depositors hold 50 percent of their money
as currency
e= 0.8 billion /800 billion = 0.001 or banks hold 0.1% of their deposits as excess
reserves.
1+c
Multiplier m=
r+e+ c
The difference is due to inclusion of currency and excess reserves in calculating the
multiplier.
(b) If the reserve ratio is increased to 15 percent, the value of the money multiplier will be,
Obviously, r and m are negatively related: m falls when r rises, and m rises when r falls.
The reason is that less multiple deposit creation can occur when r rises, while more
multiple deposit creation can occur when r falls.
Is it possible that the value of money multiplier is zero? It may happen when the interest rates
are too low and the banks prefer to hold the newly injected reserves as excess reserves with
no risk attached to it.
under WMA /OD, it results in the generation of excess reserves (i.e., excess balances of
commercial banks with the Reserve Bank). This happens because when government incurs
expenditure, it involves debiting the government balances with the Reserve Bank and cre diting
the receiver (for e.g., salary account of government employee) account with the commercial
bank. The excess reserves thus created can potentially lead to an increase in money supply
through the money multiplier process.
The existence of the credit multiplier is the outcome of fractional reserve banking. It explains
how increase in money supply is caused by the commercial banks’ use of depositors’ funds to
lend money. When a bank uses the deposited money for lending, the bank generates another
claim on a given amount of deposited money. For example, if A deposits ` 1000/ in cash at a
bank (Bank X), this constitutes the bank's current total cash deposits. If the required reserve
is 10 percent, the bank would lend ` 900/ to B. By lending B ` 900/, the bank creates a deposit
for ` 900/ that B can now use. It is as though B owns ` 900/. This in turn means that A will
continue to have a claim against ` 1000/ while B will have a claim against ` 900/. The bank
has ` 1000/ in cash against claims of ` 1900/. In short, the bank has created ` 900/ out of "thin
air" since these ` 900/ are not supported by any genuine money. At any time, the fractional
reserve commercial banks have more cash liabilities than cash in their vaults.
Now suppose B buys goods worth ` 900/ from C and pays C by cheque. C places the cheque
with his bank, Bank Y. After clearing the cheque, Bank Y will have an increase in cash of ` 900/,
which it may take advantage of and use to lend out ` 810/ to D which may again be deposited
in another bank, say Bank Z. Again 10 per cent of ` 810 (` 81) has to be kept as required
reserves and the remaining ` 719/ can be lent out, say to E. This sequence keeps on continuing
until the initial deposit amount ` 1,000 grows exactly by the multiple of required reserves (in
this case, 10%). Ultimately, the expanded credit availability would be 1000 + 900 (90% of 1000)
+ 810 (90% of 900) + 729 (90% of 810) + (90% of 719) +……. This summation would end with
an amount which is equivalent to 1/10% of 1000, which is ` 10,000. Thus, in our example, the
initial deposit is capable of multiplying itself out 10 times. In short, we find that the fact that
banks make use of demand deposits for lending it sets in motion a series of activities leading
to expansion of money that is not backed by money proper. It is interesting to know that there
is no difference between the type of money created by commercial banks and that which are
issued by the central bank.
The deposit multiplier and the money multiplier though closely related are not identical
because:
a) generally banks do not lend out all of their available money but instead maintain
reserves at a level above the minimum required reserve.
b) all borrowers do not spend every Rupee they have borrowed. They are likely to convert
some portion of it to cash.
We need to keep in mind that creating money through credit by banks does not mean creating
wealth. Money creation is not the same as wealth creation.
* 1 NOTE
While the Reserve Bank of India was pursuing all possible measures to encourage lending to
combat the negative outcomes of COVID pandemic, the banks were risk averse to lending and
were comfortable parking funds under reverse repo despite the very low reve rse repo rate of
3.35 per cent. The average deposit of funds in the overnight reverse repo window in India
increased more than three times – from an average of Rs 2.4-lakh crore during the March
quarter to Rs 7-lakh crores during the June quarter. In the month of May, banks parked nearly
` 8-lakh crores under reverse repo on a daily average basis.
Numerical illustrations
ILLUSTRATION 1
Calculate Narrow Money (M 1) from the following data
SOLUTION
M1 = Currency with public + Demand Deposits with Banking System + Other Deposits with
the RBI
= 90000 crore + 200000 crore + 280000 crore = 57 0000crore
ILLUSTRATION 2
Compute credit multiplier if the required reserved ratio is 10% and 12.5% for every ` 1, 00,000
deposited in the banking system. What will be the total credit money created by the banking
system in each case?
SOLUTION
1
Credit Multiplier =
Required Reserverd Ratio
1
For RRR = 0.10 i.e. 10% the credit multiplier = = 10
0.10
1
For RRR = 0.125i.e. 12.5% the credit multiplier = =8
0.125
1
Credit creation = Initial deposits *
RRR
For RRR 0.10 credit creation will be 1, 00,000× 1/0.10 = Rs, 10, 00,000
For RRR 0.125 credit creation will be 1, 00,000× 1/0.125= Rs, 8, 00,000
ILLUSTRATION 3
Calculate currency with the Public from the following data (` Crore)
SOLUTION
Currency with the Public (1.1 + 1.2 + 1.3 – 1.4) =(2496611+25572+743) – 98305 =2424621
ILLUSTRATION 4
Calculate M2 from the following data
(` Crore)
Notes in Circulation 2420964
Circulation of Rupee Coin 25572
Circulation of Small Coins 743
Post Office Saving Bank Deposits 141786
Cash on Hand with Banks 97563
Deposit Money of the Public 1776199
Demand Deposits with Banks 1737692
‘Other’ Deposits with Reserve Bank 38507
Total Post Office Deposits 14896
Time Deposits with Banks 178694
SOLUTION
M2 = M1+ Post Office Saving Bank Deposits
c = C/D =
400 billion/1000 billion = 0. 4 or depositors hold 40 percent of their money as currency
e= 1billion /1000 billion = 0.001 or banks hold 0.1% of their deposits as excess reserves.
Multiplier
= 1+0.4/ 0.1+0.001+0.4 = 1.5/ 0. 501 =2.79
Therefore, a 1 unit increase in MB leads to a 2.79 units increase in M.
SUMMARY
The measures of money supply vary from country to country, from time to time and
from purpose to purpose.
The high-powered money and the credit money broadly constitute the most common
measure of money supply, or the total money stock of a country.
High powered money is the source of all other forms of money. The second major
source of money supply is the banking system of the country. Money created by the
commercial banks is called 'credit money’.
Measurement of money supply is essential from a monetary policy perspective because
it enables a framework to evaluate whether the stock of money in the economy is
consistent with the standards for price stability, to understand the nature of deviations
from this standard and to study the causes of money growth.
The stock of money always refers to the total amount of money at any particular point
of time i.e. it is the stock of money available to the ‘public’ as a means of payments
and store of value and does not include inter-bank deposits.
The monetary aggregates are:
▪ M1 = Currency and coins with the people + demand deposits of banks (Current
and Saving accounts) + other deposits of the RBI;
▪ M2 = M1 + savings deposits with post office savings banks,
Following the recommendations of the Working Group on Money (1998), the RBI has
started publishing a set of four new monetary aggregates as: Reserve Money =
Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI,
NM1 = Currency with the public + Demand deposits with the banking system + ‘Other’
deposits with the RBI, NM2 = NM1 +Short-term time deposits of residents (including
and up to contractual maturity of one year),NM3 = NM2 + Long-term time deposits
of residents + Call/Term funding from financial institutions
The Reserve money, also known as central bank money, base money or high powered
money determines the level of liquidity and price level in the economy.
The money multiplier approach showing relation between the money stock and money
supply in terms of the monetary base or high-powered money holds that total supply
of nominal money in the economy is determined by the joint behaviour of the central
bank, the commercial banks, and the public.
The money multiplier is a function of the currency ratio which depends on the
behaviour of the public, excess reserves ratio of the banks and the required reserve
ratio set by the central bank.
The additional units of high-powered money that goes into ‘excess reserves’ of the
commercial banks do not lead to any additional loans, and therefore, these excess
reserves do not lead to the creation of deposits.
When the required reserve ratio falls, there will be greater multiple expansions for
demand deposits.
Excess reserves ratio e is negatively related to the market interest rate i. If interest rate
increases, the opportunity cost of holding excess reserves rises, and the desired ratio
of excess reserves to deposits falls.
When the Reserve Bank lends to the governments under WMA /OD it results in the
generation of excess reserves (i.e., excess balances of commercial banks with the
Reserve Bank).
(a) currency and coins with the people + demand deposits of banks (Current and
Saving accounts) + other deposits of the RBI.
(b) currency and coins with the people + demand and time deposits of banks (Current
and Saving accounts) + other deposits of the RBI.
(c) currency in circulation + Bankers’ deposits with the RBI + Other deposits with the
RBI
(d) empowered to issue currency to any extent by keeping a reserve of gold and
foreign securities to the extent of ` 350 crores
6. The primary source of money supply in all countries is
(b) the total supply of nominal money in the economy will vary directly with the rate
of interest and inversely with reserve money
(c) the total supply of nominal money in the economy will vary inversely with the
supply of high powered money
(d) all the above are possible
10. Under the fractional reserve system
(a) the money supply is an increasing function of reserve money (or high powered
money) and the money multiplier.
(b) the money supply is an decreasing function of reserve money (or high powered
money) and the money multiplier.
(c) the money supply is an increasing function of reserve money (or high powered
money) and a decreasing function of money multiplier.
(d) none of the above as the determinants of money supply are different
11. The money multiplier and the money supply are
(a) positively related to the excess reserves ratio e.
(b) negatively related to the excess reserves ratio e.
(c) not related to the excess reserves ratio e.
(d) proportional to the excess reserves ratio e.
12. The currency ratio represents
(a) the behaviour of central bank in the issue of currency.
(b) the behaviour of central bank in respect cash reserve ratio.
(c) the behaviour of the public.
(d) the behaviour of commercial banks in the country.
13. The size of the money multiplier is determined by
(a) the currency ratio (c) of the public,
(b) the required reserve ratio (r) at the central bank, and
(c) the excess reserve ratio (e) of commercial banks.
(d) all the above
14. _____________tells us how much new money will be created by the banking system for a
given increase in the high-powered money.
17. For a given level of the monetary base, an increase in the required reserve ratio will
denote
(a) a decrease in the money supply.
18. For a given level of the monetary base, an increase in the currency ratio causes the
money multiplier to _____ and the money supply to _____.
(a) decrease; increase
ANSWERS
1. (d) 2. (c) 3. (b) 4. (a) 5. (b) 6 (b)
13. (d) 14. (c) 15. (c) 16. (b) 17. (a) 18 (c)
19. (c)
LEARNING OUTCOMES
UNIT OVERVIEW
Monetary Policy
3.1 INTRODUCTION
We observe that the Reserve Bank of India is occasionally manipulating policy rates for
manoeuvring liquidity conditions with reasons thereof explicitly notified. In fact, we have only
a limited understanding of the monetary phenomena which could strengthen or paralyse the
domestic economy. The discussion that follows is an attempt to throw light on the well-
acknowledged monetary measures undertaken by governments to fight economic instability.
(ii) the analytics of monetary policy which focus on the transmission mechanisms, and
(iii) The operating procedure which focuses on the operating targets and instruments.
Given the development needs of developing countries, the monetary policy of such countries
also incorporates explicit objectives such as:
(i) maintenance the economic growth,
(ii) ensuring an adequate flow of credit to the productive sectors,
(iii) sustaining - a moderate structure of interest rates to encourage investments, and
(iv) creation of an efficient market for government securities.
Considerations of financial and exchange rate stability have assumed greater importance in
India recently on account of the increasing openness of the economy and the progressive
economic and financial sector reforms.
Although we know that monetary policy does influence output and inflation, we are not
certain about how exactly it does so, because the effects of such policy are visible often after
a time lag which is not completely predictable.
Monetary policy influences economic activity by changing the incentives for saving and
investment. This channel typically affects consumption, housing investment, and business
investment.
• Lower interest rates on bank deposits reduce the incentives households must save their
money. Instead, there is an increased incentive for households to spend their money
on goods and services.
• Lower interest rates for loans can encourage households to borrow more as they face
lower repayments. Because of this, lower lending rates support higher demand for
assets, such as housing.
• Lower lending rates can increase investment spending by businesses (on capital goods
like new equipment or buildings). This is because the cost of borrowing is lower, and
because of increased demand for the goods and services they supply. This means that
returns on these projects are now more likely to be higher than the cost of borrowing,
helping to justify going ahead with the projects. This will have a more direct effect on
businesses that borrow to fund their projects with debt rather than those that use the
business owners' funds.
Cash-flow Channel
• Monetary policy influences interest rates, which affects the decisions of households
and businesses by changing the amount of cash they have available to spend on goods
and services. This is an important channel for those that are liquidity constrained (for
example, those who have already borrowed up to the maximum that banks will
provide).
• At the same time, a reduction in interest rates reduces the amount of income that
households and businesses get from deposits, and some may choose to restrict their
spending.
These two effects work in opposite directions, but a reduction in interest rates can be
expected to increase spending in the Indian economy through this channel (with the
first effect larger than the second)
• Asset prices and people's wealth influence how much they can borrow and how much
they spend in the economy. The asset prices and wealth channel typically affects
consumption and investment.
• Lower interest rates support asset prices (such as housing and equities) by encouraging
demand for assets. One reason for this is that the present discounted value of future
income is higher when interest rates are lower.
• Higher asset prices also increase the equity (collateral) of an asset that is available for
banks to lend against. This can make it easier for households and businesses to borrow.
• An increase in asset prices increases people's wealth. This can lead to higher
consumption and housing investment as households generally spend some share of
any increase in their wealth.
Exchange Rate Channel
The exchange rate can have an important influence on economic activity and inflation. It is
typically more important for sectors that are export-oriented or exposed to competition from
imported goods and services.
• If the Reserve Bank lowers the cash rate it means that interest rates in India have fallen
compared with interest rates in the rest of the world (all else being equal).
• Lower interest rates reduce the returns investors earn from assets in India (relative to
other countries). Lower returns reduce demand for assets in India (as well as for Indian
rupees) with investors shifting their funds to foreign assets (and currencies) instead.
• A reduction in interest rates (compared with the rest of the world) results in a lower
exchange rate, making foreign goods and services more expensive compared with
those produced in India. This leads to an increase in exports and domestic activity. A
lower exchange rate also adds to inflation because imports become more expensive in
Indian rupees.
Banks are required to keep aside a set percentage of cash reserves or RBI approved assets.
Reserve ratio is of two types:
Cash Reserve Ratio (CRR) – Banks are required to set aside this portion in cash with the RBI.
The bank can neither lend it to anyone nor can it earn any interest rate or profit on CRR.
Statutory Liquidity Ratio (SLR) – Banks are required to set aside this portion in liquid assets
such as gold or RBI approved securities such as government securities. Banks are allowed to
earn interest on these securities, however it is very low.
Open Market Operations (OMO)
In order to control money supply, the RBI buys and sells government securities in the open
market. These operations conducted by the Central Bank in the open market are referred to
as Open Market Operations.
When the RBI sells government securities, the liquidity is sucked from the market, and the
exact opposite happens when RBI buys securities. The latter is done to control inflation. The
objective of OMOs are to keep a check on temporary liquidity mismatches in the market,
owing to foreign capital flow.
Qualitative tools
Unlike quantitative tools which have a direct effect on the entire economy’s money supply,
qualitative tools are selective tools that have an effect in the money supply of a specific sector
of the economy.
Margin requirements – The RBI prescribes a certain margin against collateral, which in turn
impacts the borrowing habit of customers. When the margin requirements are raised by the
RBI, customers will be able to borrow less.
Moral suasion – By way of persuasion, the RBI convinces banks to keep money in government
securities, rather than certain sectors.
Selective credit control – Controlling credit by not lending to selective industries or
speculative businesses.
Market Stabilisation Scheme (MSS) -
Policy Rates
Bank rate – The interest rate at which RBI lends long term funds to banks is referred to as the
bank rate. However, presently RBI does not entirely control money supply via the bank rate. It
uses Liquidity Adjustment Facility (LAF) – repo rate as one of the significant tools to establish
control over money supply.
Bank rate is used to prescribe penalty to the bank if it does not maintain the prescribed SLR
or CRR.
Liquidity Adjustment Facility (LAF) – RBI uses LAF as an instrument to adjust liquidity and
money supply. The following types of LAF are:
Repo rate: Repo rate is the rate at which banks borrow from RBI on a short-term basis against
a repurchase agreement. Under this policy, banks are required to provide government
securities as collateral and later buy them back after a pre-defined time.
Reverse Repo rate: It is the reverse of repo rate, i.e., this is the rate RBI pays to banks in order
to keep additional funds in RBI. It is linked to repo rate in the following way:
Reverse Repo Rate = Repo Rate – 1
Marginal Standing Facility (MSF) Rate: MSF Rate is the penal rate at which the Central Bank
lends money to banks, over the rate available under the rep policy. Banks availing MSF Rate
can use a maximum of 1% of SLR securities.
MSF Rate = Repo Rate + 1MSF Rate = Repo Rate + 1
3.5 CONCLUSION
The theoretical exposition of monetary policy might appear uncomplicated. However, the
choice of a monetary policy action is rather complicated in view of the surrounding
uncertainties and the need for exercising complex judgment to balance growth and inflation
concerns. Additional complexities arise in the case of an emerging market like India. There
are many challenges which need to be addressed, such as rudimentary and non-competitive
financial systems, lack of integrated money and interbank markets, external uncertainties and
issues related to operational autonomy of the central bank. Explicit inflation targeting requires
a good degree of operational autonomy for the central bank and a system in which there is a
good coordination between fiscal and monetary authorities.
SUMMARY
Monetary policy refers to the use of monetary policy instruments which are at the
disposal of the central bank to regulate the availability, cost and use of money and credit
so as to promote economic growth, price stability, optimum levels of output and
employment, balance of payments equilibrium, stable currency or any other goal of
government's economic policy.
The monetary policy framework which has three basic components, viz. the objectives
of monetary policy, the analytics of monetary policy which focus on the transmission
mechanism, and the operating procedure which focuses on the operating targets and
instruments.
Though multiple objectives are pursued, the most commonly pursued objectives of
monetary policy of the central banks across the world has become maintenance of price
stability (or controlling inflation) and achievement of economic growth.
The process or channels through which the evolution of monetary aggregates affects
the level of production and price level is known as ‘monetary transmission mechanism’
i.e how they impact real variables such as aggregate output and employment.
There are mainly four different mechanisms, namely, the interest rate channel, the
exchange rate channel, the quantum channel, and the asset price channel.
A contractionary monetary policy‐induced increase in interest rates increases the cost
of capital and the real cost of borrowing for firms and households who respond by cut
back on their investment and consumption respectively.
The exchange rate channel works through expenditure switching between domestic and
foreign goods on account of appreciation / depreciation of the domestic currency with
its impact on net exports and consequently on domestic output and employment.
Two distinct credit channels- the bank lending channel and the balance sheet channel-
operate by altering access of firm and household to bank credit and by the effect of
monetary policy on the firm’s balance sheet respectively.
Asset prices generate important wealth effects that impact, through spending, output
and employment.
Monetary policy instruments are the various tools that a central bank can use to
influence money market and credit conditions and pursue its monetary policy objectives.
There are direct instruments and indirect instruments.
The Cash Reserve Ratio (CRR) refers to the fraction of the total net demand and time
liabilities (NDTL) of a scheduled commercial bank in India which it should maintain as
cash deposit with the Reserve Bank irrespective of its size or financial position.
The Statutory Liquidity Ratio (SLR) is what the scheduled commercial banks in India are
required to maintain as a stipulated percentage of their total Demand and Time
Liabilities (DTL) / Net DTL (NDTL) in Cash, Gold or approved investments in securities.
In India, the fixed repo rate quoted for sovereign securities in the overnight segment of
Liquidity Adjustment Facility (LAF) is considered as the ‘policy rate’.
Repo or repurchase option is a collaterised lending because banks borrow money from
Reserve bank of India to fulfil their short term monetary requirements by selling
The Marginal Standing Facility (MSF) refers to the facility under which scheduled
commercial banks can borrow additional amount of overnight money from the central
bank over and above what is available to them through the LAF window by dipping into
their Statutory Liquidity Ratio (SLR) portfolio up to a limit.
Under the Market Stabilisation Scheme (MSS) the Government of India borrows from
the RBI (such borrowing being additional to its normal borrowing requirements) and
issues treasury-bills/dated securities.
Bank Rate refers to “the standard rate at which the Reserve Bank is prepared to buy or
re-discount bills of exchange or other commercial paper eligible for purchase under the
Act.
OMOs is a general term used for market operations conducted by the Reserve Bank of
India by way of sale/ purchase of Government securities to/ from the market with an
objective to adjust the rupee liquidity conditions in the market on a regular basis.
The Monetary Policy Committee (MPC) consisting of six members shall determine the
policy rate to achieve the inflation target through debate and majority vote by a panel
of experts.
(d) regulate the availability, cost and use of money and credit
(a) how money gets circulated in different sectors of the economy post monetary
policy
(b) the ratio of nominal interest and real interest rates consequent on a monetary
policy
(c) the process or channels through which the evolution of monetary aggregates
affects the level of product and prices
(a) increases the cost of capital and the real cost of borrowing for firms
(b) increases the cost of capital and the real cost of borrowing for firms and
households
(c) decreases the cost of capital and the real cost of borrowing for firms
5. During deflation
(a) the RBI reduces the CRR in order to enable the banks to expand credit and
increase the supply of money available in the economy
(b) the RBI increases the CRR in order to enable the banks to expand credit and
increase the supply of money available in the economy
(c) the RBI reduces the CRR in order to enable the banks to contract credit and
increase the supply of money available in the economy
(d) the RBI reduces the CRR but increase SLR in order to enable the banks to contract
credit and increase the supply of money available in the economy
(a) The governor of the RBI in consultation with the Ministry of Finance decides the
policy rate and implements the same
(b) While CRR has to be maintained by banks as cash with the RBI, the SLR requires
holding of approved assets by the bank itself
(c) When repo rates increase, it means that banks can now borrow money through
open market operations (OMO)
(a) OMO
(b) CRR
(c) SLR
(d) Repo
(a) The bank rate prescribed by the RBI in its half yearly monetary policy statement
(b) The CRR and SLR prescribed by RBI in its monetary policy statement
(c) the fixed repo rate quoted for sovereign securities in the overnight segment of
Liquidity Adjustment Facility (LAF)
(d) the fixed repo rate quoted for sovereign securities in the overnight segment of
Marginal Standing Facility (MSF)
(c) banks borrow money in the overnight segment of the money market
(a) the maximum repo rate that RBI can charge from government
(b) the maximum tolerable inflation rate that RBI should target to achieve price
stability.
(c) the maximum repo rate that RBI can charge from the commercial banks
(d) the maximum reverse repo rate that RBI can charge from the commercial banks
12. An open market operation is an instrument of monetary policy which involves buying or
selling of ________from or to the public and banks
13. Which statement (s) is (are) true about Monetary Policy Committee?
I. The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016, for
giving a statutory backing to the Monetary Policy Framework Agreement and for
setting up a Monetary Policy Committee
II. The Monetary Policy Committee shall determine the policy rate through debate
and majority vote by a panel of experts required to achieve the inflation target.
III. The Monetary Policy Committee shall determine the policy rate through
consensus from the governor of RBI
IV. The Monetary Policy Committee shall determine the policy rate through debate
and majority vote by a panel of bankers chosen for eth purpose
(a) I only
ANSWERS
1. (d) 2 (b) 3 (c) 4. (b) 5. (a) 6. (b)
13. (b)