Money Monetary Aggregates and Monetary Policy Smita 1

Money, Monetary Aggregates and Monetary Policy Smita 1

Money • • 1. 2. 3. 4. India follows Minimum Reserve System. Monetary Aggregates used to define Money in India are – M 1 – Narrow Money M 2 M 3 – Broad Money M 4 2

Old Monetary Aggregates The Reserve bank of India uses 4 concepts to define the ‘Money supply’ in India. These ‘Money Supply’ terms are also called as Money Stock Measures OR Monetary Aggregates. They are as follows: • M 1: This is Currency with the public + Demand Deposits with Banks + OD with RBI. It is also called as Narrow Money. • M 2 : M 1 + Post office Savings Deposits. It is also termed as Narrow Money • M 3 : M 3 is broad Money i. e. M 1 + Aggregate Deposits of the Public with Banks which is made up of Demand Deposits and Time Deposits. • M 4 : M 4 refers to M 3 and Post Office Deposits. It is also termed as Broad Money. 3

What is Reserve Money? • Reserve money is also called central bank money, monetary base, base money, high-powered money. In the most simple language, Reserve Money is Currency in Circulation plus Deposits of Commercial Banks with RBI plus 'other' deposits with RBI. • MO (Reserve Money) = Currency in Circulation + Bankers' Deposits with the RBI + 'Other' Deposits with RBI 4

You Tube Video • https: //youtu. be/IMk. Fc 863 Nqk • https: //youtu. be/W 3 k 7 Gw 39 OHI 5

New Monetary Aggregates • In view of growth of Financial Markets over the years, need was felt to bring in various institutions that hold money or contribute to liquidity in financial markets within the definition of money supply in India. Some of these entities are: • ‘Financial Institutions’ other than banks. Example are: IFCI, SIDBI etc. • NBFC – Non Banking Financial Companies Hence New Monetary Aggregates were proposed and are accepted. 6

New Monetary Aggregates ( Based on Y. V. Reddy Committee Report) • M 1 = C + DD + OD (Same as earlier definition) • M 2 = M 1 + CD’s (certificate of Deposits) issued by banks + Term Deposits maturing in a year. • M 3 = M 2 + Term Deposits of Over a year + Call/Term borrowings of banks • M 4 = Abolished now. 7

Liquidity Aggregates in India • L 1 = M 3 + All Deposits with post Offices • L 2 = L 1 + Term deposits with term lending institutions + CD’s issued by FI’s. • L 3 = L 2 + Public Deposits with NBFC’s. 8

Factors affecting Money Supply is affected mainly by two factors viz. Monetary base and Money Multiplier. • Monetary Base: As the reserve money changes, money supply also changes in the same direction. This means if there is more of reserve money in the system, money supply increases. • Money Multiplier: Money Multiplier is the ratio of the Narrow Money (M 1) or the Broad Money (M 3) to Reserve Money. • Supply of money is product of Money Multiplier (m) and the amount of high powered money or the Reserve money. 9

Credit Creation Capacity of Banks • Money supplied by commercial banks to economy is called credit money. • Commercial banks create credit by advancing loans. • They lend money to individuals and businesses out of deposits accepted from the public. • However, commercial banks cannot use the entire amount of public deposits for lending purposes. • They are required to keep a certain amount as reserve with the central bank for serving the cash requirements of depositors. After keeping the required amount of reserves, commercial banks can lend the remaining portion of public deposits 10

Credit Creation (contd. ) • Suppose you deposit Rs. 10, 000 in a bank A, which is the primary deposit of the bank. The cash reserve requirement of the central bank is 10%. In such a case, bank A would keep Rs. 1000 as reserve with the central bank and would use remaining Rs. 9000 for lending purposes. • The bank lends Rs. 9000 to Mr. X by opening an account in his name. Now, Mr. X writes a cheque of Rs. 9000 in favor of Mr. Y to settle his earlier debts. • Mr. Y has account with Bank B Receives Rs. 9000. It will maintain 10% of it as Cash Reserve and will lend remaining Rs. 8, 100 11

Multiple deposit expansion process Bank A B C D E F Acquired reserves and deposits 10000 9000 8100 7290 6561 5904. 9 Required reserves 1000 900 810 729 656. 1 590. 49 Excess reserves 9000 8100 7290 6561 5904. 9 5314. 41 New money created 9000 8100 7290 6561 5904. 9 5314. 41

Credit Creation Process q. Total Credit Creation = Original Deposit * Credit Multiplier Coefficient q. Credit multiplier coefficient= 1 / r where r = cash reserve requirement also called as Cash Reserve Ratio (CRR) q. Credit multiplier co-efficient = 1/10% = 1/ (10/100) = 10 q. Total credit created = 10, 000 *10 = 100000 q. If CRR changes to 5%, Credit multiplier co-efficient = 1/5% = 1/ (5/100) = 20 Total credit creation = 10000 * 20 = 200000 13

MONETARY POLICY 14

Monetary Policy • Monetary policy is the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity. 15

Monetary and Credit Policy Tools CRR SLR Bank Rate Open market Operations and MSS (Market Stabilization Scheme) • Repo transactions - LAF (initiated from 2000) • Banking Guidelines • • 16

CRR – Cash Reserve Ratio • CRR is the amount of funds that banks have to maintain with the Reserve Bank of India (RBI) at all times. If the central bank decides to increase the CRR, the amount available with the banks for disbursal comes down. • The RBI uses the CRR to drain out excessive money from the system or vice versa. • Commercial banks are required to maintain an average cash balance with the RBI as stipulated under CRR guidelines of RBI. • Minimum level of CRR is 3% of the total of Net Demand Time Liabilities (NDTL). The RBI is empowered to increase the CRR to ≤ 20% of the NDTL. 17

CRR- NDTL • The NDTL (Net Demand Time Liabilities) is the total volume of liabilities on which the bank needs to maintain CRR with the RBI. • DTL includes demand liabilities like current account deposits, savings account deposits, margins held against L/Cs & guarantees, outstanding TT/MT/DD and call money borrowings. • Time liabilities include fixed deposits, cash certificates, recurring deposits etc. 18

SLR • Every bank must have a specified portion of their Net Demand Time Liabilities (NDTL) in the form of cash, gold, or other liquid assets by the day’s end (Government securities and Government approved Securities). • The ratio of these liquid assets to the demand time liabilities is called the Statutory Liquidity Ratio (SLR). 19

Bank Rate • Bank rate is the rate charged by the central bank for lending funds to commercial banks. • In other words it is the rate of interest charged by the central bank on the loans they have extended to commercial banks and other financial institutions is called “Bank Rate”. • In case of extending facility at Bank Rate, the RBI does no repurchasing agreement, no securities are sold or collateral is involved. • Bank Rate is usually higher than Repo Rate. 20

Open Market Operations • Open market operations or OMOs are conducted by the Reserve Bank of India (RBI) by way of sale and purchase of GSecs (government securities) to and from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis. • When the Reserve Bank feels that there is excess liquidity in the market, it resorts to sale of securities thereby sucking out the rupee liquidity. • Similarly, when the liquidity conditions are tight, RBI may buy securities from the market, thereby releasing liquidity into the market. 21

MSS – Market Stabilization Scheme • Open Market Operations (OMO) is buying and selling of Government securities to manage money supply in the economy. Thus, it is used to both inject and withdraw liquidity. Moreover, these securities are a part of Government borrowing. • On the other hand MSS is only selling of Government securities to withdraw excess liquidity. The money raised through the selling of securities is kept in a separate account known as MSS account. 22

MSS • The Market Stabilization Scheme (MSS) was launched in April 2004. During 2002 -2004, there were huge capital inflows into India. This led to an appreciation of the rupee (because demand for Indian rupee increased). Appreciation of rupee is not good for exports as it makes exports more expensive. • To combat this, the RBI sold Government securities to withdraw the excess liquidity. The selling of Government securities depleted the limited stock of securities held by the RBI. • This withdrawal of excess liquidity is also known as sterilisation. 23

What is LAF? • A liquidity adjustment facility (LAF) is a tool used in monetary policy, used by the Reserve Bank of India (RBI), to enable banks to borrow money through repurchase agreements (repo) or to enable banks to lend to the RBI using reverse repo contracts. • This arrangement manages liquidity pressures and ensures basic financial-market stability in short run. • The short run here refers to period of 1 t 0 14 days. 24

What is Repo Rate? • The rate at which the RBI lends money to commercial banks is called repo rate. It is an instrument of monetary policy. Whenever banks face a shortage of funds, they can borrow from the RBI as per the repo rate. A reduction in repo rates helps banks get money at a cheaper rate and vice versa. The repo rate in India is similar to the discount rate in the US. 25

What is Reverse Repo • Reverse repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money is in safe hands and earns good interest. • An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system. 26

y Monetary Policy Rate Changes introduced on March 27, 2020 Policy rate New Rate Previous Rate Change in Basis points (bps) Policy Repo Rate 4. 40 % 5. 15% 75 Reverse Repo Rate 4% 4. 90% 90 Marginal Standing Facility Rate 4. 65% 5. 40% 75 Bank Rate 4. 65% 5. 40% 75 CRR 3% 4% 100 SLR 18. 25% – 27

You Tube Videos on Monetary Policy • https: //youtu. be/Gm 8 LZc. TUmf 8 • https: //youtu. be/QAef. M 8 Oau. Tk • https: //youtu. be/Cw. RNDLHgl 3 g 28