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Monetary Aggregates (As on Aug 2020)

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Monetary Aggregates (As on Aug 2020)

INR tn

I. M0 (Reserve money) (1.1 + 1.2 + 1.3)


1.1. Currency in Circulation (CiC) (a+b)


a. Notes


b. Coins


1.2 Bankers' deposits with RBI


1.3 Other deposits with RBI


II. M1 (2.1 + 2.2 + 2.3)


2.1 Currency with public (a-b)


a. CiC


b. Cash in hand with banks


2.2 Demand deposits with banks


2.3 Other deposits with RBI


III. M2 (3.1 + 3.2)


3.1 M1


3.2 Post office savings bank a/c


IV. M3 (4.1 + 4.2)


4.1 M1


4.2 Time deposits with banks


V. M4 (5.1 + 5.2)


5.1 M3


5.2. Total post office deposits (savings + time )


  • 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

  • M = m x B

  • 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:

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

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

  • 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


  • 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

  • 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


To finance government deficit through sale of g-secs

  • How do Governments finance spending?

  • Govts can finance their spending in 3 ways –

  1. by taxes,

  2. by borrowing form the public through issue of bonds,

  3. 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


  • 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

  1. 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)

monetary policy, preventing over-heating of the economy,

  • If inflation is less than the target, RBI would follow expansionary

monetary policy to stimulate growth

  1. 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

  1. 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

  1. OMOs

  • Directly aids Government’s borrowings &spending → stimulates


  • 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

  1. 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


  1. 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


  1. 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


  • 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

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













  • 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





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Santanu Sengupta

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