Money

Sessions 06-07
Kinds of Money
• Commodity money: Money that takes the form of a
commodity with intrinsic value. Eg. Gold, cigarettes

• Private Money: Money issued by private entities eg. Bitcoins

• Will it be more stable than government money?
• Niall Ferguson – Ascent of Money

• Intrinsic value: Item would have value even if it were not used
as money

• Gold standard-Gold as money OR paper money that is

convertible into gold on demand
Kinds of Money

• Fiat money: Money without intrinsic value

• Used as money because of government decree

• Fiat: Order or decree

The Central Bank

Central Monetary Authority in an economy

• Functions
• Authority to issue currency / currency management
• Banker to the Government
• Banker to the Banks
• Lender of last resort
• Regulating the financial sector
• Management of forex and other reserves
Tools of Monetary Policy

• Open Market Operations: Central bank buys or sells short-term

securities in open market

• Bank Rate: Rate at which RBI lends to the banks

• Variable Reserve Requirements

• Cash Reserve Ratio: Reserves kept by banks with RBI
• Statutory Liquidity Ratio: Reserves kept by banks with themselves in form
of notified securities and gold

• Repo rate

• Moral suasion
Money Supply
• Money:
• Currency + Demand deposits
• Can influence the quantity of demand deposits in the economy (and the
money supply)

• Reserves: Deposits that banks have received but have not loaned
out
• The simple case of 100% reserve banking – All deposits are held as
reserves – Banks do not influence the supply of money
First National Bank
Assets Liabilities
Reserves 100 Deposits 100
Money Supply

• Fractional-reserve banking: Banks hold only a fraction of

deposits as reserves
• Reserve ratio: Fraction of deposits that banks hold as
reserves
• Reserve requirement: Minimum amount of reserves
that banks must hold; set by the Central Bank

• Excess reserve: Banks may hold reserves above the legal

minimum
Money Supply
• Example: 10% Reserve ratio
First National Bank
Assets Liabilities
Reserves 10 Deposits 100
Loans 90
Second National Bank
Assets Liabilities
Reserves 9 Deposits 90
Loans 81

Third National Bank

Assets Liabilities
Reserves 8.1 Deposits 81
Loans 72.9
Money Supply

• Original deposit = $100.00

• First National lending = $ 90.00 [= .9 × $100.00]
• Second National lending = $ 81.00 [= .9 × $90.00]

• Third National lending = $ 72.90 [= .9 × $81.00]

...
• Total money supply = Original Deposit x 1/RR = 100 x 1/0.1 =
$1,000.00
• Money Multiplier: 1/RR
Bank Capital
Realistic National Bank
Assets Liabilities
Reserves 200 Deposits 800
Loans 700 Debt 150
Securities 100 Equity 50

• Leverage: Use of borrowed money to supplement existing

funds for purposes of investment
• Leverage ratio: Ratio of assets to bank capital
• Capital requirement: Government regulation specifying a
minimum amount of bank capital
Financial Crisis

If bank’s assets rise in value by 5%

• Because some of the securities the bank was holding rose in
price
• $1,000 of assets would now be worth $1,050
• Bank capital rises from $50 to $100
• So, for a leverage rate of 20
• A 5% increase in the value of assets
• Increases the owners’ equity by 100%
Financial Crisis
If bank’s assets are reduced in value by 5%

• Because some people who borrowed from the bank default on

their loans

• $1,000 of assets would be worth $950

• Value of the owners’ equity falls to zero

• So, for a leverage ratio of 20

• A 5% fall in the value of the bank assets
• Leads to a 100% fall in bank capital
• The Bank would be insolvent (unable to pay its liabilities)
• Reduces a Bank’s ability to lend
Money in the Indian Economy

• Money stock: Quantity of money circulating in the

economy

• Currency: Paper bills and coins in the hands of the

public

• Demand deposits: Balances in bank accounts;

depositors can access on demand by writing a check

• Time Deposits: Deposits for a fixed time period.

Old Measures of Money Stock

• M1 • M3
• Currency with the Public(+) • M1(+)
• Demand deposits with the • Time deposits of the Banking
Banking system(+) system
• Other deposits with the RBI(+)
• M4
• M2 • M3 (+)
• M1(+) • All deposits of post-office
• Savings deposits of post-office savings bank
savings banks
New Measures of Money Stock
• NM0 (Reserve Money) • NM2
• Currency in Circulation(+) • NM1(+)
• Bankers’ deposits with the RBI (+) • Short term time deposits (including
• Other deposits with RBI and up to the contractual maturity
of one year)
• NM1
• NM3
• Currency with the Public [Currency
in circulation – Currency in Banking • NM2(+)
system] (+) • Long term time deposits of residents
• Demand deposits with the Banking • Call/Term funding from financial
system (+) institutions
• Other deposits with the RBI
Money Supply in India

Source: RBI Bulletin October 2024

Sources of Money Stock (M3)
2023-24 2023 2024
Aug 25 Jul 26 Aug 09 Aug 23
1 Net Bank Credit to 7512016 7274511 7612861 7674995 7629866
Government
2 Bank Credit to 16672145 15052452 17084181 17155454 17224460
Commercial Sector
3 Net Foreign Exchange 5543700 4993999 5736662 5773433 5866203
Assets of Banking
Sector
4 Government’s 33432 31400 34306 34306 34306
Currency Liabilities to
the Public
5 Banking Sector’s Net 4929674 4026453 4877557 4910172 5050735
Non-monetary
Liabilities
M3(1+2+3+4–5) 24831618 23325909 25590453 25728017 25704100
Source: RBI Bulletin October 2024
Money Multiplier

Money Stock = M M = CU + D = (cu + 1)D

Currency = CU H = CU + R = (cu + re)D
Deposits = D Thus,
High Powered Money = H M=
! # $%
H = mm x H
&' # $%
Reserves = R
Smaller re and cu à larger the Money
Currency-deposit ratio = cu = CU/D
Multiplier (mm)
Reserve ratio = re = R/D
The Financial System
• Financial system: the group of institutions in the economy that
help to match one person’s saving with another person’s
investment.
• Financial Markets are the institutions through which savers can
directly provide funds to borrowers.
• Bond Market
• Stock Market
• Financial Intermediaries are financial institutions through
which savers can indirectly provide funds to borrowers.
• Banks
• Investment Funds
Financial Instruments - Bond

• A bond is a certificate of indebtedness that specifies

obligations of the borrower to the holder of the bond.

• Characteristics of a Bond.
• Term: The length of time until the bond matures.

• Credit Risk: The probability that the borrower will fail to pay
some of the interest or principal.

• Government bonds.
• The safer the credit risk the lower the interest rate.
Inflation Tax

• When the government raises revenue by printing

money, it is said to levy an inflation tax.

• Reduces the value of money with the public and

increases the money in the hands of the government
• https://www.forbes.com/sites/johngoodman/2024/06/02/the-inflation-
tax/#:~:text=The%20authors%20find%20that%20a,tax%20on%20the%20couple's%20wealth.
Hyperinflation
• Hyperinflation is a period of extreme and accelerating increase in
the price level where the monthly rate exceeds 50 per cent.

• Usual Sequence of events:

• The government has a high level of spending and inadequate tax revenue to
pay for its spending.

• The government’s ability to borrow funds is limited.

• As a result, it turns to printing money to pay for its spending.

• The large increases in the money supply lead to large amounts of inflation.

• The hyperinflation ends when the government cuts it’s spending and
eliminates the need to create new money.
Fisher Effect

• Fisher effect refers to a one-to-one adjustment of the nominal

interest rate to the inflation rate.

• When the rate of inflation rises, the nominal interest rate

rises by the same amount.

• The real interest rate stays the same.

Fisher Effect

US: CPI and Nominal Interest on 3-month Treasury Bills

Cost of Inflation
• Shoeleather costs
High inflation à high opportunity cost of holding money à less cash holding à
more trips to the bank

• Menu costs

• Relative price variability

• Tax distortions

• Confusion and inconvenience

• Arbitrary redistribution of wealth

• Lenders loose creditors gain

• Inflation Tax
Even when there is indexation
Inflation and Tax Burden
Deflation

• Deflation where the price level actually falls.

• A period of deflation affects both lenders and borrowers
• Deflation can be as damaging as inflation because:
• There is little incentive to spend today if the expectation is for
cheaper prices tomorrow.
• It might result in consumers not spending at levels that provide
incentives for firms to invest in new capacity.
• Leading to little or no growth and with that….
• An increased likelihood of unemployment.