Monetary Policy and Money Supply

8/3/2019 Monetary Policy and Money Supply

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Monetary Policy

RBI and Monetary Policy in India


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What is Monetary Policy?

The term monetary policy refers to actions takenby central banks to affect monetary magnitudesor other financial conditions.

Monetary Policy operates on monetarymagnitudes or variables such as money supply,interest rates and availability of credit.

Monetary Policy ultimately operates through itsinfluence on expenditure flows in the economy.

In other words affects liquidity and by affectingliquidity, and thus credit, it affects total demandin the economy.


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Credit Policy Central Bank may directly affect the money

supply to control its growth. Or it might act indirectly to affect cost and

availability of credit in the economy.

In modern times the bulk of money in developed

economies consists of bank deposits rather thancurrencies and coins.

So central banks today guide monetarydevelopments with instruments that control overdeposit creation and influence general financialconditions.

Credit policy is concerned with changes in thesupply of credit.

Central Bank administers both the Credit and

Monetary policy


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Aims of Monetary policy

MP is a part of general economic policy of thegovt.

Thus MP contributes to the achievement of thegoals of economic policy.

Objective of MP may be:Full employment

Stable exchange rate

Healthy BoP

Economic growth

Reasonable Price Stability

Greater equality in distribution ofincome & wealth

Financial stability


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Price Stability: The Dominant

Objective There is convergence of views in developed and

developing economies, that price stability is the

dominant objective of monetary policy.

Price stability does not mean complete year-to-

year price stability which is difficult to attain.

Price stability refers to the long run average

stability of prices. Price stability involves avoidance of both

inflationary and deflationary pressures.


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Contd..

Price Stability contributes improvements in thestandard of living of people.

It promotes saving in the economy whilediscouraging unproductive investment.

Stable prices enable exports to compete ininternational markets and contribute to thestrengthening of BoP.

Price stability leads to interest rate stability, andexchange rate stability (via export import

stability). It contributes to the overall financial stability ofthe economy.


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Operation of Monetary

Policy

Instruments

1. Discount Rate

(Bank Rate)

2.Reserve Ratios

3. Open Market

Operations

Operating

Target

Monetary Base Bank Credit

Interest Rates

Intermediate

Target

Monetary

Aggregates(M3)Long term

interest rates

Ultimate

Goals

Total Spending

Price Stability

Etc.


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Instruments of Monetary Policy

Variations in Reserve Ratios

Discount Rate (Bank Rate)

(also called rediscount rate) Open Market Operations (OMOs)

Other Instruments


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Variations in Reserve Ratios

Banks are required to maintain a certainpercentage of their deposits in the form ofreserves or balances with the RBI

It is called Cash Reserve Ratio or CRR

Since reserves are high-powered moneyor base money, by varying CRR, RBI can

reduce or add to the banks requiredreserves and thus affect banks ability tolend.


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Discount Rate (Bank Rate) Discount rate is the rate of interest charged by the

central bank for providing funds or loans to thebanking system.

Funds are provided either through lending directly orrediscounting or buying commercial bills and

treasury bills. Raising Bank Rate raises cost of borrowing by

commercial banks, causing reduction in creditvolume to the banks, and decline in money supply.

Variation in Bank Ratehas an effect on t

hedomestic interest rate, especially the short term

rates.

Market regards the increase in Bank rate as theofficial signal for beginning of a tight money

situation.


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Open Market Operations (OMOs)

OMOs involve buying (outright ortemporary) and selling of govt securitiesby the central bank, from or to the public

and banks. RBI when purchases securities, pays the

amount of money by crediting the reserve

deposit account of th

e sellers bank, wh

ich

in turn credits the sellers deposit accountin that bank.


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Money Supply

Currency issued by government fiduciary

supply

Money supply is expressed in two broadmeasures Narrow money and Broad

Money


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Monetary Magnitudes

Reserve Money (M0): Currency in circulation + Bankers deposits with the

RBI + Other deposits with the RBI

M1: Currency with the public + Deposit money of the public (Demand

deposits with the banking system + Other deposits with the RBI).

M2: M1 + Savings deposits with Post office savings banks. M3: M1+ Time deposits with the banking system

M4: M3 + All deposits with post office savings banks (excluding National

Savings Certificates).


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Currency Growth


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Money supply

how the banking system creates money

three ways t

he RBI can control t

he moneysupply

why the RBI cant control it precisely


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Banks role in the money supply

The money supply equals currency plusdemand (checking account) deposits:

M = C + D

Where

C = Currency with Public

D = Demand deposits with Public

Since the money supply includes demanddeposits, the banking system plays animportant role.


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A few preliminaries

Reserves(R): the portion of deposits that bankshave not lent.

To a bank, liabilities include deposits,

assets include reserves and outstanding

loans

100-percent-reserve banking: a system in which

banks hold all deposits as reserves.

Fractional-reserve banking:a system in which banks hold a fraction of their

deposits as reserves.


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SCENARIO 1: No Banks

With no banks,

D = 0 and M = C = Rs.1000.


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SCENARIO 2: Fractional-Reserve Banking

The money supply

now equals Rs.1800:

The depositor still

has Rs.1000 in

demand deposits,

but now the

borrowerholds

Rs.800 in currency.

FIRSTBANKSbalance sheet

Assets Liabilities

deposits Rs.1000

Suppose banks hold 20% of deposits in reserve, making loans withthe rest.

Firstbank will make Rs.800 in loans.

reserves

Rs.1000

reserves Rs.200

loans Rs.800


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The money supply

now equals Rs.1800:

The depositor still

has Rs.1000 in

demand deposits,

but now the

borrowerholds

Rs.800 in currency.

FIRSTBANKSbalance sheet

Assets Liabilities

reserves Rs.200

loans Rs.800

deposits Rs.1000

Thus, in a fractional-reservebanking system, banks create money.


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But thenSecondbank will

loan 80% of this

deposit

and its balance

sheet will look like

this:

SECONDBANKSbalance sheet

Assets Liabilities

reserves Rs.800

loans Rs.0

deposits Rs.800

Suppose the borrower deposits the Rs.800 in Secondbank.

Initially, Secondbanks balance sheet is:

reserves Rs.160

loans Rs.640


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THIRDBANKSbalance sheet

Assets Liabilities

reserves Rs.640

loans Rs.0

deposits Rs.640

If this Rs.640 is eventually deposited in Thirdbank,

then Thirdbank will keep 20% of it in reserve, and loan the rest out:

reserves Rs.128

loans Rs.512


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Finding the total amount of money:

Original deposit = Rs.1000

+ Firstbank lending = Rs. 800

+ Secondbank lending = Rs. 640

+ Thirdbank lending = Rs. 512+ other lending

Total money supply = (1/rr )v Rs.1000

where rr = ratio of reserves to deposits

In our example, rr = 0.2, so M = Rs.5000


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Money creation in the banking system

A fractional reserve banking systemcreates money,

but it doesnt create wealth:

bank loans give borrowerssome new money

and an equal amount of new debt.


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A model of the money supply

the monetary base, B = C + R

controlled by the central bank

C = Currency with Publi

c

R= Currency deposits fo Comm. Banks with RBI

the reserve-deposit ratio, rr = R/D

depends on regulations & bank policies

the currency-deposit ratio, cr= C/D

depends on households preferences

exogenous variables


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The H Theory of Money Supply

Currency

with PublicC

Currency

with Public

C

Cash

ReservesR

Demand DepositsD

B= C+R


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The Money Multiplier

The supply of money is the multiples of cashreserves

One rupee kept as bank reserves gives rise tomuch more amount of demand deposits

The relation ship between Base money andmoney supply is determined by moneymultiplier(m)

m = M / BRearranging we have

M = B.m


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A model of the money supply

the monetary base, B = C + R

controlled by the central bank

C = Currency with Publi

c

R= Currency deposits fo Comm. Banks with RBI

the reserve-deposit ratio, rr = R/D

depends on regulations & bank policies

the currency-deposit ratio, cr= C/D

depends on households preferences

exogenous variables


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slide 30

Solving for the money supply:

M C D! C D

BB

! v m B! v

C D

C R

!

1cr

cr rr

!

C DmB

!

where

C D D D

C D R D

!


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The money multiplier

Ifrr

< 1, then

m

> 1 If monetary base changes by (B,

then (M = m v (B

m is called the money multiplier.

,M m B! v1

wherecr

mcr rr

!


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Money Supply

Y

X

Money Supply

0

MS1 MS2

Rate ofInterest


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Money Demand

Y

X0

Rate ofInterest

Quantity of Money

i3

i2

i1

M1 M2 M3

Md

Md

Two set economy

1.Currency in Hand + DD

2. Bonds

If the interest rates are

high high opportunity

cost for holding cash

bonds can earn higher

returns than holding cash

which does not pay any

returns


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Money Demand

Y

X0

Rate ofInterest

Quantity of Money

i3

i2

i1

M1 M2 M3

Md1

Md1

Md2

Md2

If the level of incomeincrease the money

demand curve will shift

right


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Money market Equilibrium

Money market is in equilibrium at a rate of

interest when demand for money is equal

to the fixed money supply

MS = MD


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0

InterestRate

Quantity Of Money (Crores of Rupees)

Money Market Equilibrium

Money supply

9

7E1

The amount of money

demanded (held) dependson interest rates

LO1

5E2

E3

M1 M2M3

Excess money supply at

a given interest rate

people buys bonds

raises bonds

decreases interest rates

Increases the quantity of

money demanded will

be equal to money

supply and vice versa


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If there is excess money supply at a given

interest rate people buys bonds raises

bonds decreases interest rates

It increases the quantity of money

demanded will be equal to money supply


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0

InterestRate

Quantity Of Money (Crores of Rupees)


Money supply

9

7E1

The amount of money

demanded (held) dependson interest rates

LO1

M

E2


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Link between goods market and

money market Goods market Equilibrium Money market equilibrium

IS LM Model


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Goods market Equilibrium


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Goods market Equilibrium1. If interest rates decrease, Investments Increase and

aggregate demand will increase Higher will be the

equilibrium of national income

2. If the interest rates increases, investments will

decrease , aggregate demand will decrease lowerwill be the equilibrium of national income

3. By joining points A, B & D we will get IS Curve

4. IS curve slopes downwards decrease in interestrates increases national Income and vise versa

5. IS curve may shift due government expenditure


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LM Curve1. Is derived from Keynesian theory

2. Greater the level of income greater the money held for

transaction motive, the money Demand curve will be

higher

3. Money supply has to match the higher money demand

4. LM curve is derived by connecting intersections

different money demand curves and money supply

curves corresponding to different levels of income


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Simultaneous equilibrium of Goods Market

and money market

Point at which Goods

market is in equilibrium

and Money market is inequilibrium


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IS-LM Curve1. Investment demand function

2. Consumption function

3. Money demand function

4. Quantity of money

Saving and investment, productivity of capital andpropensity to consume and save, demand for money

and supply of money all these factors determine the

rate of interest and level of income.

Changes in the factors will shift the equilibrium of IS-LMCurves


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If supply of money is high, interest rates

will fall, LM curve will shift right


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Inflation In economics, inflation is a persistent rise in the

general level of prices of goods and services in

an economy over a period of time

Inflation also reflects an erosion in the purchasing

power of money a loss of real value

A chief measure of price inflation is the inflation rate,the annualized percentage change in a general price

index (normally the Consumer Price Index) over time.


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Inflation

Negative effects - decrease in the real value of money and

other monetary items over time, uncertainty over future

inflation may discourage investment and savings, and high

inflation may lead to shortages of goods if consumers

begin hoarding out of concern that prices will increase in

the future.

Positive effects - ensuring central banks can

adjust nominal interest rates (intended to

mitigate recessions),and encouraging investment in non-monetary capital projects.


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Inflation

Inflation Price Inflation and Money inflation

Excess money supply will lead to price inflation


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Inflation

Headline inflation is a measure of the total inflationwithin an economy and is affected by areas of the

market which may experience sudden inflationary spikes

such as food or energy

Inflationary Spikes- sudden price rise in some

commodities

Hyperinflation is inflation that is very high or out of

control. Hyperinflation often occurs when there is a largeincrease in the money supply not supported by gross

domestic product (GDP) growth


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Inflation

Stagflation combination of stagnation and inflation

Suppressed inflation govt. polices suppress inflation

Disinflation keeping the inflation rates lower

Deflation opposite to inflation prices fall persistently

revenues for producers fall- low investments fall in

demand fall in incomes

An inflationary gap, in economics, is the amount by

which the real Gross domestic product, or real GDP,

exceeds potential GDP


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Inflation rates around the world


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Inflation rates in India


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Causes of Inflation

The quantity theory of inflation rests on the quantity equation ofmoney, that relates the money supply, its velocity, and the nominal

value of exchanges.

Currently, the quantity theory of money is widely accepted as an

accurate model of inflation in the long run. Consequently, there isnow broad agreement among economists that in the long run, the

inflation rate is essentially dependent on the growth rate of money

supply.


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Keynesian view

Keynesian economic theory proposes that changes in

money supply do not directly affect prices, and thatvisible inflation is the result of pressures in the

economy expressing themselves in prices.

There are three major types of inflation, as part ofwhat Robert J. Gordon calls the "triangle model

Demand pull inflation

Cost push inflationBuilt-in-inflation


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Demand-pull inflation is caused by increases in aggregatedemand due to increased private and government

spending, etc. Demand inflation is constructive to a faster

rate of economic growth since the excess demand and

favourable market conditions will stimulate investment andexpansion.

increase in money supply

increase in disposable income

increase in aggregate spendingincrease in population of the country


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Cost-push inflation, also called "supply shock inflation," is

caused by a drop in aggregate supply (potential output).

This may be due to natural disasters, or increased prices of

inputs. For example, a sudden decrease in the supply of oil,leading to increased oil prices, can cause cost-push

inflation. Producers for whom oil is a part of their costs could

then pass this on to consumers in the form of increased

prices.

Built-in inflation is induced by adaptive expectations, and is

often linked to the "price/wage spiral". It involves workers

trying to keep their wages up with prices (above the rate of

inflation), and firms passing these higher labor costs on totheir customers as higher prices, leading to a 'vicious circle'.

Built-in inflation reflects events in the past, and so might be

seen as hangover inflation.


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Measuring InflationGenerally the inflation is measured using price index

Price index is a numerical measure that helps to compare prices of someclass of goods and services between time periods

Current years Price

Price index = ------------------------------ X 100

Base years Price

Producer price indices (PPIs) which measures average changes in prices

received by domestic producers for their output

consumer price index (CPI) measures changes in the price level

of consumer goods and services purchased by households.

Wholesale Price Index (WPI) is the price of a representative

basket of wholesale goods. Some countries (like India and The Philippines)

useWPI changes as a central measure of inflation.


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Inflation rate

Inflation rate =

The percentage increase in the price of goods and services,

usually annually.


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WPI & CPI


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Wage Price Spiral


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Impact of inflation

Negatives

Cost push Inflation wage spiral

Hoarding

Social unrests and revolts

Hyperinflation

Loss of allocative efficiency by producers

Shoe leather costs more trips to banksBusiness cycles

Positives

Labor-market adjustments

Room to maneuver to change interest rates

Mundell-Tobin effect savers will be induced to lend portion of money reduces interest rates


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Inflation and unemployment

An economic concept developed by A. W. Phillips stating that

inflation and unemployment have a stable and inverse relationship.

According to the Phillips curve, the lower an economy's rate of

unemployment, the more rapidly wages paid to labor increase in

that economy.

he theory states that with economic growth comes inflation, which

in turn should lead to more jobs and less unemployment. However,

the original concept has been somewhat disproven empirically due

to the occurrence of stagflation in the 1970s, when there were high

levels of both inflation and unemployment.


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Philips Curve short Run


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Philips Curve Long Run


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I fl ti V U l t


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Inflation Vs Unemployment

Trade off

Monetary Policy and Money Supply

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