Session 14 Money, Banking and Monetary Policy I

Money and the Monetary System
What is money? Functions of money

Money is the set of all assets that are regularly used to
directly purchase goods and services.
Money serves three main functions:
1. Store of value: Money represents a certain amount of
purchasing power.
2. Medium of exchange: money can be used to purchase
goods and services.
• A barter system is where people directly offer a good or
service for another good or service.
3. Unit of account: money provides a standard unit of

comparison.
What makes for good money?
There are two basic considerations that make certain
money better than others.
Stability of value:
• Early versions of money generally took the form of a
physical material that was durable and had intrinsic value.
• Money does not need intrinsic value to maintain stability.
Convenience:
• Technology has allowed for the development of more
convenient forms of money.
• For example, paper money is more convenient than gold
coins.
Commodity-backed money versus fiat money
Any form of money that can be legally exchanged into a
fixed amount of an underlying commodity is commodity-
backed money.
• The most common underlying commodity is gold or
foreign currency.
Money created by rule, without any commodity backing it,
is fiat money.
• U.S. currency is backed only by the trust that the
government will keep the value of money relatively
constant.
Measuring money
The money supply is the amount of money available in the
economy.
• The money supply is managed by the Central Bank.
The Central Bank classifies different types of money by their
liquidity.
• The monetary base includes cash and bank reserves,
sometime referred to as hard money.
• M1 includes cash plus checking account balances.
• M2 includes M1 plus savings accounts and other financial
instruments.
Measuring money continued
Each measure provides a distinct understanding
of the financial system.
Hard money, M1, and M2 over time
Trillions of U.S. dollars • M1 indicates liquidity.
14
M
• M2 indicates savings.
12
• M2 is a measure of the
10
9 money multiplier when
8
6
7 compared to the
5
4 Monetary base
monetary base.
3 M
2
1
0
1984 1989 1994 1999 2004 2009 2014
Source: RBI Bulletin, September 2017
Managing the money supply
The central bank is the institution responsible for
managing the nation’s money supply and coordinating the
banking system.
In the U.S., the central bank is the Federal Reserve, which
has been mandated by Congress to conduct monetary
policy to perform two essential functions:
1. Manage the money supply.
2. Act as a lender of last resort.
Monetary policy refers to the actions made by the central bank
to manage the money supply.
Managing the money supply
The Fed has a twin or dual mandate:
• Ensuring price stability: Enacting monetary policy that
meets the needs of the economy while keeping prices
constant over time.
• Maintaining full employment: Enacting monetary policy
that keeps the economy strong and stable.
Watch the video in the link below.
• http://www.cc.com/video-clips/2l8p98/the-colbert-report-
fed-s-dead
Tools of monetary policy
The Fed achieves these mandates by managing the money
supply through three main tools.
1. The reserve requirement is the amount of money banks
must hold in reserve.
2. The discount window is the lending facility that allows
banks to borrow reserves from the Fed.
• The discount rate is the interest rate charged by the Fed for
loans through the discount window.
3. Open-market operations are sales or purchases of
government bonds by the Fed to or from banks on the
open market.
Tools of monetary policy
These transactions directly impact the money supply.
• Contractionary monetary policy is when money supply is
decreased to lower aggregate demand.
• Expansionary monetary policy is when money supply is
increased to raise aggregate demand.
Open market operations also affect the inter-bank lending
market, the federal funds market.
• The federal funds rate is the interest rate at which banks
lend reserves to one another.
The Fed affects the federal funds rate through changes in
the supply of reserves by conducting contractionary and
expansionary monetary policy.
Tools of Monetary Policy
Cash reserve ratio (CRR)
The ratio of a bank’s time and demand liabilities to be kept in reserve with the
RBI.
Statutory liquidity ratio (SLR)
Banks have to invest a certain percentage of its time and demand liabilities in
govt. approved securities.
Liquidity Adjustment Facility (LAF)
Consists of daily infusion or absorption of liquidity on a repurchase basis, through
repo and reverse repo
Repo Rate
Repo rate is the rate at which the RBI lends shot-term money to the banks
Reverse Repo Rate
The rate at which RBI borrows from commercial banks.
Marginal Standing Facility (MSF)
Commercial banks can borrow over night at their discretion up to one per cent of
their respective NDTL
Bank rate
Bank Rate is the rate at which central bank of the country allows finance to
commercial banks in the long term.
Open market operations
Moral suasion & prudential
13
Reserve Requirements
RBI regulations that require banks to hold a minimum

reserve-deposit ratio.
Cash Reserve Ratio (CRR)

CRR is the ratio of a bank’s cash holdings with RBI to its
total deposit liabilities.
Banks hold CRR at the RBI and no regular interest is

earned on the balance held at the RBI.
Advantages of CRR
If RBI wants to reduce money supply, it increases the CRR

and vice versa.
Good for big changes in ‘Ms’.
Changing the CRR has no cost, it remains the favored

method in India.
– CRR rule does not apply to Regional Rural Banks,
Non Banking Financial Companies (NBFC), Mutual
funds or insurance companies.
Disadvantages of CRR
An increase in CRR has undesirable side effects on bank profits.
Example: For SBI, a 4% CRR works out more than Rs 50,000 crore
which won’t attract any interest.
A news clip
Cannot obtain small changes in “M”.
Success depends on bank behavior with respect to excess

reserves. Banks with low excess reserves can be in trouble if the
ratio is changed. Cannot change often.
Statutory Liquidity Ratio (SLR):
Monetary policy tool which indirectly influence MS
SLR refers to the rate at which banks are required to

maintain their reserves in most liquid assets
(government securities).
Through SLR, RBI changes the deposits available for

lending purpose thereby influence MS.
The govt. imposes an obligation on the banks to use a

proportion of cash to buy govt. securities.
Repos and Reverse Repos
The Liquidity Adjustment Facility (LAF) introduced in

June 2000 emerged as the principal operating
instrument for modulating short-term liquidity.
Consequently, the repo rate (the rate at which banks

borrow funds from the RBI against collateral) and the
reverse repo rate (the rate at which banks place their
funds with the RBI and receive collateral) emerged as
the key instruments for signaling the monetary policy
stance.
Marginal standing facility (MSF)
Marginal standing facility, this is for long term with respect to LAF.
In the case of LAF banks cannot sell Government security to RBI
that is part of bank's SLR quota but it can borrow any amount of
money as long as it has the GOVT securities to sell.
But with MSF banks can sell the Government security from its SLR
quota to RBI but it can maximum borrow up to 2% of its Net
Demand and Time Liabilities (NDTL) outstanding at the end of
second preceding fortnight. .
Suppose repo rate is "r%" then MSF lending rate is always (r+x)
%.
20
Open-Market Operations
 Increase money supply

– RBI buys bonds
• Open-market purchase
 Reduce money supply

– RBI sells bonds
• Open-market sale
Open-Market Operations
• Open-market operations, which take place in the “open
market” for bonds, are the standard method central banks use
to change the money stock in modern economies.
• If the central bank buys bonds, this operation is called an

expansionary open market operation because the central bank
increases (expands) the supply of money.
• If the central bank sells bonds, this operation is called a

contractionary open market operation because the central
bank decreases (contracts) the supply of money.
Advantages of OMO
• OMO are fully under the central bank’s control and can
be undertaken in fine, small, or large quantities.
• Quickly implemented, easily reversed.
 Tool of choice for the RBI

 Influences bank reserves
 Influences RBI funds rate
– Interest rate
– Borrowing among banks
– Of excess reserves at RBI
Bank Rate
 The discount rate or bank rate

– Interest rate, RBI
– For loans made to banks
 Bank borrow ‘Discount window’
– Satisfy reserve requirements
 RBI
– Lender of last resort
Rates
Policy Repo Rate : 5.150%
Reverse Repo Rate : 4.9%
Marginal Standing Facility Rate : 5.4%
Bank Rate : 5.4%
CRR : 4%
SLR : 18.5%
The economic effects of monetary policy
The liquidity-preference model The liquidity-preference

model refers to the idea
that the quantity of money
people want to hold is a
function of the interest rate.
• This means the money
demand curve slopes
downward.
• The RBI sets the money
supply, which means the
money supply curve is
set by monetary policy.
The liquidity-preference model explains how the RBI’s actions
can change interest rates.
Shifts in the money supply curve
• Expansionary
monetary policy results
in a higher quantity of
money and lower
interest rates.
• Contractionary
monetary policy results
in a lower quantity of
money and higher
interest rates.
The slope of the money demand curve affects the amount of
change in the interest rate.
The more elastic money demand… The more inelastic money demand…
….smaller the effect on interest rates. …greater effect on interest rates.
The money supply
For each of the following situations, indicate the effect
(increase or decrease) on the money supply and interest
rate.
Change in money
Situation Change in interest rate
supply
The RBI conducts open-market

Blank Blank
bond purchases.
The RBI sells government

Blank Blank
bonds on the open market.
The money supply Solution
For each of the following situations, indicate the effect
(increase or decrease) on the money supply and interest
rate.
Change in money
Situation Change in interest rate
supply
The RBI conducts open-market

Increase Decrease
bond purchases.
The RBI sells government

Decrease Increase
bonds on the open market.
Expansionary monetary policy
Expansionary monetary policy Expansionary monetary policy and the AD/AS model
Interest rate, r Price level

LRAS
MS 1 MS 2 SRAS
P2
r1 P1
r2 AD2
Money
demand
AD1
Q1 Q2 Y1 Y2
Quantity of money Real GDP
• During a recession, expansionary • The aggregate demand curve shifts out.

monetary policy decreases the interest • Price and output increase.
rate.
• Cheaper to borrow and less rewarding
to save money.
Contractionary monetary policy
Contractionary monetary policy Contractionary monetary policy and the AD/AS model
Interest rate, r Price level
LRAS
MS MS SRAS
2 1
P1
r2 P2
r1 AD1
AD2
MD
Q2 Q1 Y2 Y1
Quantity of money Real GDP
• During overheating, contractionary • The aggregate demand curve shifts in.

monetary policy increases the interest • Prices and output decrease.
rate.
• More expensive to borrow and
encourages saving.
Challenges and advantages of monetary policy
Analyzing the use of monetary policy shows how policy can
work in ideal cases, but it is rare for the world to work so
cleanly.
Challenges
• The RBI faces time lags and imperfect information.
• A few months can pass before the RBI’s actions make their
impact- 2 to 3 quarter to have an impact on prices and 6 to 8
quarters to have an impact on output.
• Mistiming of monetary policy could make economic conditions
worse.
• Moreover, many high-income countries have found, monetary
policy loses much of its effectiveness at the zero lower bound
(Importance of Unconventional monetary policy).
Challenges and advantages of monetary policy
Advantages
• The RBI does not have to wait for politicians to come to a
policy consensus.
• The RBI is made up of prominent economic policy-makers.
• It is their job to make sure they fully understand the nuances
of the overall economy.
video for next session
https://www.youtube.com/watch?
v=iPkJH6BT7dM

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Session 14 Money, Banking and Monetary Policy I

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Money and the Monetary System

What is money? Functions of money

3. Unit of account: money provides a standard unit of

RBI regulations that require banks to hold a minimum

Cash Reserve Ratio (CRR)

Banks hold CRR at the RBI and no regular interest is

If RBI wants to reduce money supply, it increases the CRR

Good for big changes in ‘Ms’.

Changing the CRR has no cost, it remains the favored

Cannot obtain small changes in “M”.

Success depends on bank behavior with respect to excess

SLR refers to the rate at which banks are required to

Through SLR, RBI changes the deposits available for

The govt. imposes an obligation on the banks to use a

The Liquidity Adjustment Facility (LAF) introduced in

Consequently, the repo rate (the rate at which banks

 Increase money supply

 Reduce money supply

• If the central bank buys bonds, this operation is called an

• If the central bank sells bonds, this operation is called a

• Quickly implemented, easily reversed.

 Tool of choice for the RBI

 The discount rate or bank rate

Reverse Repo Rate : 4.9%

Marginal Standing Facility Rate : 5.4%

Bank Rate : 5.4%

The liquidity-preference model The liquidity-preference

The RBI conducts open-market

The RBI sells government

The RBI conducts open-market

The RBI sells government

Interest rate, r Price level

• During a recession, expansionary • The aggregate demand curve shifts out.

• During overheating, contractionary • The aggregate demand curve shifts in.

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