Goods market
Monetary Aggregates (As on Aug 2020)
- Navigate this page:
- Money supply is proportional to the monetary base
- What happens when R/D ratio gets lowered
- Fractional reserve banking
- But, what if the depositors do withdraw at same time
- Case study: PMC Bank, Yes Bank
- Why would the central bank increase the money supply
- 1. Interest Rate
- Interest Rate
- 4% rate (with +/-2% band)
- Bank reserve requirement tool
- FX purchases / sales tool
- LTROs TLTROs
- 5. LTROs TLTROs
| Monetary Aggregates (As on Aug 2020)
| |
|
INR tn | |
|
I. M0 (Reserve money) (1.1 + 1.2 + 1.3) |
31.9 |
|
1.1. Currency in Circulation (CiC) (a+b) |
26.8 |
|
a. Notes |
26.5 |
|
b. Coins |
0.3 |
|
1.2 Bankers' deposits with RBI |
4.7 |
|
1.3 Other deposits with RBI |
0.4 |
|
II. M1 (2.1 + 2.2 + 2.3) |
42.9 |
|
2.1 Currency with public (a-b) |
25.8 |
|
a. CiC |
26.8 |
|
b. Cash in hand with banks |
1 |
|
2.2 Demand deposits with banks |
16.6 |
|
2.3 Other deposits with RBI |
0.4 |
|
III. M2 (3.1 + 3.2) |
44.3 |
|
3.1 M1 |
42.9 |
|
3.2 Post office savings bank a/c |
1.4 |
|
IV. M3 (4.1 + 4.2) |
176.5 |
|
4.1 M1 |
42.9 |
|
4.2 Time deposits with banks |
133.6 |
|
V. M4 (5.1 + 5.2) |
180.6 |
|
5.1 M3 |
176.5 |
|
5.2. Total post office deposits (savings + time ) |
4.1 |
Total M3 stock = Rs 177L Cr of
Currency issued by central bank as notes & coins = 15%
Bank deposits = 85%
Money circulating in the economy > Actual notes & coins printed
HOW?
Commercial banks also create money
Rather than banks lending out deposits placed with them, the act of lending itself creates deposits
Bank deposits are created by commercial banks themselves
What does the central bank do?
Rather than controlling the quantity of reserves, CBs set the price of
reserves, which is, interest rates
The act of lending itself creates deposits. HOW?
When a loan is given → the bank does not hand over physical
currency to people taking the loan
It credits their bank account with a bank deposit of the size of the loan. At that moment, new money is created
Thus, commercial banks don’t simply act as intermediaries, they
create money, in the form of bank deposits, by making new loans
Money multiplier relationship:
Money supply (M)=> currency + deposits (C+D) determined by transaction demand for money
Monetary base (B)=> currency + reserves (C+R)
Dividing M by B:
M / B = (C + D) / (C + R)
Dividing numerator and denominator of RHS by D:
M / B = (C / D + 1) / (C / D + R / D)
C/D → currency to deposit ratio (cr) → amount of currency C held
as a fraction of deposits, depending on preferences determined by transaction demand
R/D → reserve to deposit ratio (rr) → fraction of deposits bank held
as reserves, determined by central bank → called cash reserve ratio
M = [ (cr + 1) / (cr + rr) ] x B
Thus:
M = m x B
Or:
m = (cr + 1) / (cr + rr)
Money multiplier
Money supply is proportional to the monetary base
Monetary base or central bank money gets multiplied up by the
money multiplier
• => By changing the monetary base, the central bank can change
the money supply
What happens when R/D ratio gets lowered?
→ Banks make more loans → more money is created
Decrease in R/D ratio → raises money multiplier & money supply
Consider the following scenario:
HDFC Bank gets Rs 1000 as deposit, & 10% is the reserve reqd by
the RBI → It will hold 10% as reserve and lend out → Rs 900
Rs 900 → borrowed to buy a car → money goes in the car dealer’s
bank account (e.g. ICICI bank)
ICICI gets Rs 900 deposit. ICICI can loan out of it after setting aside
10% rr → Rs 810 can be loaned out now by ICICI
This process goes on and takes the form of a geometric series but
ends upto a finite limit.
The finite limit as we have seen is = ( 1 / reserve requirement ) →
the money multiplier
Hence an initial deposit can lead to a bigger final increase in the
total money supply
Money gets ‘multiplied’ → banks are not required to hold the entire
deposit → only hold a fraction of it as reserves & loan out the rest
Fractional reserve banking:
Only a fraction of bank deposits are backed by actual cash in hand
Rest is available for lending to expand the economy
Banks can create money through lending. Reserve requirement
doesn’t pose a binding constraint to credit growth
This does not mean that commercial banks can create credit freely
without any limit
Banks are limited in how much they can lend if they are to remain
profitable in a competitive banking system
Prudential regulations act as a constraint on banks’ activities so as
to maintain the resilience of the financial system
Example: The requirement for Basel capital & liquidity place balance
sheet limits on banking credit and money creation
Fractional reserve banking system → banks lend much more than
they hold in the form of actual cash
Helps expand the economy by increasing lending
Assumption → not all depositors withdraw at the same time, so
banks need to only hold on to a fraction of their deposits
But, what if the depositors do withdraw at same time?
‘Bank run’→ fear that a bank will fail, depositors withdraw their
money to protect their own deposits
Failure of one bank→ risk of breakdown of entire financial system
due to inter-dependence
Fractional reserve banking creates a fragile and a highly inter-
dependent financial system
Govt’s place deposit insurance guarantees →Depositors get % of
deposits back → Govt. backs certain % of public’s deposits
Case study: PMC Bank, Yes Bank
Sub-prime lending → the risk of default rises
Highly inter-dependent financial system → one default causes
multiple defaults and this spreads like a contagion
After GFC, Basel regulations for banks have been enhanced
such that banks don’t indulge in unnecessary risk-taking
The flip-side is risk-aversion during downturns → banks are
less willing to lend during downturns → stalling credit flow at
a time when it’s needed the most
Blanchard: Pg 123 to 128
Quantity of money is related to prices and incomes
Money x Velocity = Price x Transactions
M.V=P.T
Also, MV = PY,
Y= output, as transactions and output are related
V is called the transactions velocity of money and measures the
rate at which money circulates in the economy
Velocity tells us the number of times a currency note changes
hands in a given period of time
For a given Velocity and Output, if money supply rises→ directly
leads to an increase in price level in the economy
% change in price is Inflation. Too much money chasing too few goods
If the central bank keeps the Ms stable, P usually remains stable. If the central bank increases Ms rapidly, P may rise rapidly
Why would the central bank increase the money supply
substantially?
To finance government deficit through sale of g-secs
How do Governments finance spending?
Govts can finance their spending in 3 ways –
by taxes,
by borrowing form the public through issue of bonds,
by coaxing the central bank to print more money
Seigniorage → revenue raised by the printing of money
Mankiw Pg 92 to 94
1. Interest Rate:
RBI targets inflation through the repo rate→ rate at which commercial banks borrow from RBI, keeping Govt securities as collateral
Lower interest rates incentivize lending and help in stimulating the
economy
Reverse repo rate → rate at which commercial banks park their
excess reserves with RBI, earning a rate of interest
Lower reverse repo rate incentivizes lending as banks are
incentivized to lend more from their deposits to earn better return
Interest Rate:
RBI’s mandate → flexible inflation targeting → targeting inflation
while also maintaining growth.
As per the mandate→ RBI endeavors to keep inflation controlled at
4% rate (with +/-2% band)
If the inflation is above this target, RBI would follow contractionary
monetary policy, preventing over-heating of the economy,
If inflation is less than the target, RBI would follow expansionary
monetary policy to stimulate growth
Bank reserve requirement tool
RBI can change Cash Reserve Ratio (CRR) or Statutory Reserve
Ratio (SLR)
Decrease in CRR →banks have to maintain less as RBI reserves→
can lend more → stimulating the economy
SLR → % of banks’ net demand & time liabilities (NDTL), which
banks have to keep invested in liquid assets like Govt securities
Decrease in SLR → that much space from the deposits is freed for
private lending → hence is an expansionary measure
OMOs
RBI auctions Govt securities in the primary market
Different financial market players like banks, insurance companies,
FIIs, pension funds buy G-secs
Demand from buyers is less → RBI comes in secondary market & buys G-sec holdings from market players → giving the players and the system more liquidity
Helps market absorb higher G-sec supply when market players might not have the appetite to absorb it fully→ giving market players more confidence
OMOs
Directly aids Government’s borrowings &spending → stimulates
economy
If RBI increases the amount of OMOs it conducts → directly
increases liquidity in the hands of financial market players →
increasing appetite to buy more G-sec
FX purchases / sales tool
RBI also buys or sells foreign exchange → aids or sucks out rupee
liquidity from the system
If RBI wants to inject liquidity in system→ buys foreign currency in
the FX market in exchange of rupee → enhance rupee liquidity. This is to prevent speculative attacks
RBI wants to suck out liquidity in the system → sells foreign
currency in exchange of rupee → thus take away excess rupee
liquidity
FX purchases / sales tool
RBI has to do this in a calibrated manner as it directly impacts the
exchange rate
When RBI buys FX, it leads to a depreciation of the rupee
From Dec 2019 to Oct 2020 → RBI has injected ~Rs 7L Cr of rupee
liquidity through forex purchases
Forex reserves rose sharply from $457bn in Dec’19 to $552 bn in
Oct’20
LTROs & TLTROs
Repo rate offers banks short-term financing.
Objective of LTRO→ provide banks with financing at the prevailing
repo rate up to 3 years
This is done to prevent risk aversions during recessions and extend credit to the real economy.
This ensures availability of durable liquidity at lower cost
Helps in credit augmentation& helps banks to better match their
asset-liability tenors
5. LTROs & TLTROs
TLTROs are an extension of LTRO
Banks are mandated to deploy the funds they raise through LTROs in corporate bonds, commercial paper, etc issued by entities in specific sectors
Objective → extend easy financing throughout the system through
such operations and thus enhance credit growth
Banks first decide their lending decisions & then set out their
mandated reserves.
They have to maintain mandated CRR
RBI’s Liquidity Adjustment Facility (LAF) →the key element in
monetary policy implementation process
Individual banks fall short of their reserve requirement → borrow
funds from the interbank market → borrow funds from RBI
Recall Repo and reverse Repo rate
Similarly, they park excess reserves with the RBI if it cannot be
lent in the inter-bank market
System liquidity deficit: If the banking system as a whole is a net borrower from the RBI under LAF window
System liquidity surplus: If the banking system as a whole is a net
lender to the RBI. Trades at Reverse Repo
Suppose banks hold Rs 150tn Net Demand &Time Liabilities (NDTL), Rs 102tn credit, and Rs 47.5tn as reserve assets
|
Sources of funds |
INR tn |
Deployment of funds |
INR tn |
|
NDTL |
150 |
Credit |
102 |
|
|
CRR |
8.5 | |
|
|
SLR + HQLA |
39.0 | |
|
Total |
150 |
Total |
150 |
2 types of Reserve assets
CRR → mandate from RBI →minimum 3% of NDTL as reserves
SLR → mandate from RBI → minimum 18.25% as NDTL in the form
govt. securities
High Quality Liquid Assets (HQLA) → cover 30 days of expected
outflows → not static like SLR.
Assume, total SLR + HQLA → 23% of NDTL i.e Rs 34.5tn
Min amount of reserve assets required = Rs 4.5 + Rs 34.5 = Rs 39tn
Banks have surplus CRR balance of Rs 4tn over the statutory
requirement of Rs 4.5tn
Banks haven’t been able to lend much → Banking system surplus
Banks have surplus SLR + HQLA requirement of Rs 4.5tn over
statutory requirement
Banks have overall excess statutory reserves of Rs 8.5tn
When banks park their excess CRR balances with RBI, they park it
against the reverse repo rate in the LAF window
If CRR balances < Rs 4.5tn → banks borrow from RBI’s LAF window
under policy repo rate → banking system liquidity is in deficit
https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=50747
https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=50746
https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=20257
https://www.rbi.org.in/scripts/FS_Overview.aspx?fn=2752
https://www.livemint.com/opinion/online-views/a-fresh-capital-crisis- looms-over-india-s-banking-sector-11603814755059.html
Santanu Sengupta
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