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Money Demand and Supply Functions

Money Demand and Supply Functions. CHAPTER 8. 1. Significance of Money. One of the three great inventions Factor of production: lubricant Vehicle of monetary policy Money, a part of private wealth but not of national wealth. 2. What is Money?. Commodity money:

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Money Demand and Supply Functions

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  1. Money Demand and Supply Functions CHAPTER 8

  2. 1. Significance of Money • One of the three great inventions • Factor of production: lubricant • Vehicle of monetary policy • Money, a part of private wealth but not of national wealth

  3. 2. What is Money? • Commodity money: - Need not be a precious metal or RBI issued or even legal tender, but acceptable as a medium of exchange and for settling debts • Fiat money: Legal tender • Narrow and broad money • Functions of money: • - Medium - Measure – Standard – Store • Near money assets

  4. 3. Demand for Money • Why people / firms hold money ? * J. M. Keynes proposed that people hold money for three reasons: • Transactions (certain) • Precautionary (uncertain) L1 / P • Speculative (uncertain) • (asset demand) L2 / P

  5. 4. Determinants of Money Demand 4.1: Income • Classical : • MV = PT (Irving Fisher) (8.1) M / P = kY (Cambridge) (8.2) • Keynes dichotomy : - Income determines L1 / P - Interest rate (nominal) determines L2 / P (asset demand for money)

  6. 4. Determinants of Money Demand – contd. Figure 8.1: Classical money demand function

  7. 4. Determinants of Money Demand – contd. Figure 8.2: Interest sensitiveness of money demand – L2/P * Liquidity trap at i = i1

  8. 4. Determinants for Money Demand – contd. 4.2 Interest rate (nominal) * Opportunity cost of money = Return on fin. assets = Nominal interest rate • Keynes L2 : Liquidity trap • Milton Friedman: Return on all assets, including physical assets • Bond price (BP) and interest rate BP = I/(1+i) + I/(1+i)2 + ------- or, BP = I / i (8.3)

  9. 4. Determinants of Money Demand – contd. 4.3 Expected inflation Since nominal interest rate (i) = real interest rate (r) + expected inflation rate (= cost of holding money against real assets), expected inflation rate affects money demand negatively. 4.4 Wealth Income includes return on wealth

  10. 4. Determinants of Money Demand – contd. 4.5 Boumol-Tobin synthesis • Average cash holdings (uniform spending) (monthly Y) = = , If N = 1 = = Y / 2 N, if N >1 - Discrete vs continuous data

  11. 4. Determinants of Money Demand – contd. * Minimize cost of cash holding for transactions: (8.4) (8.5)

  12. 4. Determinants of MoneyDemand – contd. Figure 8.3: Cost of cash holding

  13. 4. Determinants of MoneyDemand – contd. * Average cash holdings for transactions per period = => L1 = (8.6) • Square root formula - Economies of scale • Other determinants of money demand: Credit availability, expected future income, payments system, nature and availability of money substitutes. • More money is held by black economy holders and criminals.

  14. 5. Money Demand Function (8.7) f1 > 0 > f2 • Assumes no Money Illusion • Roles of ATM / credit cards and other financial innovations * Case study / Applications * Stable untill 1970 * Over predicted Md during 70s, under predicted during 80s * Loss of monetarism

  15. 6. Money Supply 1. Money Components, Issuers and Systems • Fiat Money: - Govt. and RBI monopoly producer - Seigniorage • Currency • - Coins and one rupee notes: Govt. of India, need based • Non-one rupee notes : RBI’s Issue department: • * Currency, the liability • * Gold, forex assets and govt. securities, the assets - Fixed currency reserve system

  16. 6. Money Supply – contd. • Bank Deposits - Liability of the banking sector - Banks’ assets are reserves with RBI and vault cash, investments, loans, and physical assets - Branch Vs. unit banking - Fractional reserve system - CRR and SLR - Reserves: required, excess and free - Primary (genuine / passive) & secondary (credit / active) deposits • Sources of Broad Money Supply

  17. 7. Table 8.1: Sources of Broad Money Supply in India (Rs. Billions / end of period) Source 1990-91 2000-01 2005-06 1. Net bank credit to government 1402 5120 7691 * RBI’s 888 1539 81 * Other banks’ 514 3581 7610 2. Bank credit to commercial sector 1718 6792 16910 * RBI’s 63 133 14 * Other banks’ 1655 6659 16896 3. Net foreign assets of banking sector 106 2498 7262 * RBI’s 80 1972 6730 * Other banks’ 26 526 532 4. Government currency liabilities to public 16 54 88 5. Banking sectors’ net monetary liabilities other than demand & time deposits 583 1331 4655 * RBI’s 270 793 1240 * Other banks’ 313 538 3415 6. Broad money (M3) (1+2+3+4-5) 2,658 13,132 27,295

  18. 8. Multiple Creation of Deposits(Fractional Reserve System) * Example: Initial primary deposits of Rs. 1,000 (assume: Reserve ratio (r) = 20%) a. LiabilitiesAssets Deposits Rs. 1,000 Reserves (cash) Rs. 1,000 b. LiabilitiesAssets Deposits Rs. 1,000 Reserves Rs. 200 Loans Rs. 800 c. LiabilitiesAssets Deposits Rs. 800 Reserves Rs. 160 Loan Rs. 640

  19. 8. Multiple Creation 0f Deposits – contd.(Fractional Reserve System) d. Rs. 1,000 [ 1+ (1 - 0.20) + (1 - 0.20)2 + ........] = = Rs. 5,000 e. Formula: Change in D = Change in R/r * Note: Deposits not out of thin air f. Deposit multiplier = 1/r * Pros and cons of fractional reserve system g. Assumptions / Limitations • No cash leakage • No change in r

  20. 9. Money Supply Function • 3.1 Definitions • M = C + D (8.8) H = C + R (8.9) • 3.2 Money Multiplier (m) 

  21. 9. Money Supply Function – contd. or, (8.10) (8.11) M = m H (8.12) • 3.3 Money Supply Function  M = f (H, CRR, i, u) (8.13) f1, f3 > 0 > f2

  22. Table 8.2 Issue Department of RBI ( Rs. Billions / End of year) Table 8.3: Components of Reserve Money ( Rs. Billions/End of year) Component 1990-91 2000-0 2005-06 -------------------------------------------------------------------------------------------------- 1. Currency in circulation 553 2182 4307 * With public 531 2095 4131 * With banks 22 87 176 2. “Other” deposits with RBI 7 36 69 3. Bankers’ deposits with RBI 318 815 1355 4. Reserve money (1+2+3) 878 3033 5731

  23. Table 8.5: Sources of Reserve Money (Rs. Billions/End of year) Source 1990-91 2000-01 2005-06 1. RBI’s claims on * Government 888 1539 81 * Commercial & cooperative banks 69 64 28 * National bank for agri. & rural dev. 31 66 30 * Commercial sector 63 133 14 2. Net foreign assets of RBI 80 1972 6730 3. Govt. currency liabilities to public 16 54 88 4. Net non- monetary liabilities of RBI 270 793 1240 5. Reserve money (1+2+3-4) 878 3033 5731 _________________________________________________________________

  24. 10. Determinants of Money Supply • High-powered money (+ve): Autonomous • Interest rate (+ve) • CRR and SLR (-ve): Monetary policy instruments • Sterilisation: Policy variable *

  25. 11. Banking Structure in India • Resreve Bank of India (RBI) • State Bank of India and seven subsidiaries • Nationalized (public sector) banks (20) * 1969: 14 * 1973: 6 • Private commercial banks: Old and new Indian and foreign * Universal - Reverse merger • Cooperative banks

  26. 12. Issuance of Money Supply • Under gold standard • Pure / Bullion / Exchange • Under dollarisation • Under currency union / common currency • Under currency board • Under proportional / fixed / no currency reserve • Fixed foreign exchange rate • Flexible foreign exchange rate • Govt. budget constraint

  27. 13. Instruments of Monetary Policy • Open Market Operations (OMO) / sterilization • Cash Reserve Ratio (CRR) - Statutory liquidity ratio (SLR) • Bank Rate - Liquidity adjustment facility - Repo / Reverse repo rates • Selective Credit Controls • Moral Persuasion

  28. 14. Conduct of Monetary Policy • RBI independent ! • Objective / focus of monetary policy ? • Monetary anchor: Money or interest rate ? • Monetary targeting: with / without revision ?

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