Money, Banking and

Financing

CHAPTER 26 GOODWIN Dr. Manika Bora

ET.AL
 MONEY, BANKING AND
AGGREGATE DEMAND
Money facilitates the process of employing factors of production to
produce goods and services in ana economy.
 Individuals and firms regularly approach the banks to take loans for
their consumption and production needs.
 For this the banks determine the creditworthiness of the borrower, offer
or deny loans with certain terms and conditions including charging an
interest on the loan.
 Governments play a role in the economy also by influencing the volume
and terms of loans that the banks can lend; also affecting the spending in
the economy.
What happens if the government
finds it difficult to raise enough tax
revenues to pay for its expenses?
 PRINTING MONEY
If economy is large and growing compared to
government expenses, fresh printed money will be
absorbed.
But otherwise, we find ourselves in the “ too much
money chasing too few goods” scenario
Germany after WW I, Hungary after WW II, Bolivia
in1980s, Argentina during various periods, Ukraine in
the early 1990s, and Zimbabwe in 2008–9 –(annual
inflation rate higher than 100 percent – hyperinflation)
Normal patterns of saving and lending are disrupted –
can wipe out savings
Valueless currency
High inflation disruptive in an economy
 DEFLATION AND FINANCIAL
CRISES
 Too little money in circulation, as a result prices fall – falling prices
 Implications: Borrow “cheap” money, but pay back with money that is “expensive”
- wealth is redistributed from debtors to creditors
- cut back on spending
 Great Depression : Bank runs meant people tried to withdraw their deposits all at
once, banks collapsed and price level dropped by 25 %
 Deflation in Japan: Following a banking crisis in 1989, situation of recession and
deflation, for over two decades; severe cut back on consumption spending, creating
expectations of further falling prices
 Deflation curbs growth of businesses and economy
 WHAT IS MONEY FOR AN
ECONOMIST?
Stock variable, highly liquid Types of Money
(intrinsic/exchange)
1. Medium of exchange  Commodity money: generally
acceptable, standardized,
https://www.theatlantic.com/bu durable, portable, scarce, and
siness/archive/2016/02/barter- divisible
society-myth/471051/
 Fiat Money: Basis of value,
2. Store of value/stock variable removed from the earlier
gold/silver form/social
3. Unit of account construction
 Extreme short term
WHAT IS MONEY? shortage of paper
currency.
How did the citizens
manage in this monetary
shock?

• Digital payments
• Barter and credit
extensions

MONEY IS NOT JUST A

PIECE OF PAPER WITH
THE PROMISE TO PAY
SIGNED BY THE
Currency in circulation India (2014–2020) AUTHORITY
 MEASURES OF MONEY
 Different liquidity in assets creates confusion about which assets are money
and which are not.
 When economists measure a country’s “money supply,” only currency that is
in circulation is included—that is, not currency sitting in a vault at the Mint or
at a bank
 M1 = Currency with the public + Demand deposits with the banking system
+ ‘Other’ deposits with the RBI
M2 = M1 + Savings deposits of post office savings banks
 M3 = M1+ Time deposits with the banking system
LIQUIDITY CONTINUUM
 Amount
As on March 11 , 2022 (Rs.
Crore)

M3 (broad money) 1665793

Components (i+ii+iii+iv)

i) Currency with the Public 259288

ii) Demand Deposits with Banks 226110

iii) Time Deposits with Banks 1174510

iv) `Other ' Deposits with Reserve Bank 5884

 BANKING SYSTEM
Private banks
A private bank is a type of institution called a financial intermediary
Individuals and organizations deposit funds with financial intermediaries, for
safekeeping, to provide the convenience of writing checks, or to earn interest
The financial intermediaries use the funds deposited with them to make loans to
individuals and organizations that seek to borrow funds
For-profit business - by charging interest (and perhaps other fees) on the loans
 Screens the parties seeking loans, in order to determine their creditworthiness
 BALANCE SHEET OF A
PRIVATE BANK
Double entry accounting representation with a private bank’s assets and liabilities

If confidence in the bank diminishes, depositors withdraw money and banks face
insufficient liquidity
MONETARY POLICY
 HOW BANKS CREATE MONEY?

 In a world without banks, money supply would be all the currency held by
people.
 In a world where there is a bank but holds all the money as reserve.
Assets Liabilities
Reserves Rs 100 Deposits Rs 100

Money supply decreases by the amount of currency out of circulation but

increases by the demand deposit in the bank
 What if bank reconsiders its position of holding all deposit as reserve?
FRACTIONAL RESERVE
BANKING
Assets Liabilities
Loans Rs 90 Deposits Rs 100
Reserves Rs 10

 Let reserves be 10 percent of deposits.

 The money supply now includes – demand deposits worth 100 rupees but the
borrowers now hold Rs. 90 as currency by way of the loans.
 Therefore money supply is equal to currency plus demand deposits, i. e. Rs 190.
 Assets for the bank are liability for the borrower, but the economy has more
circulation of money.
MONEY MULTIPLIER
Now suppose Rs 90 borrowed from the bank are used to buy goods and services, and the
producer of the goods in turn deposits the money in the bank.

Assets Liabilities
Loans Rs 81 Deposits Rs. 90
Reserve Rs 9

 What if Rs 81 was once again deposited by another person in a third bank?

Assets Liabilities
Loans Rs 72.90 Deposits Rs. 81
Reserve Rs. 8.1

 Money is created each time a deposit is made in the bank

 MONEY MULTIPLIER
How much money is eventually created in this economy? Let’s add it up:
Original deposit Rs. 100.00
First round of lending Rs. 90.00 (= 0.9 * 100)
Second round of lending Rs. 81.00 (=0.9 * 90)
Third round of lending Rs. 72.90 (= 0.9 * 81)
• •
• •
Adding up the numerous rounds of lending and deposit we find that reserve of Rs. 100 creates an
infinite series : (1 + x + x2 + x3 + … + xn) = 1/(1 – x) where x =0.9
Total money supply of Rs. 1,000.00
Money multiplier = Money supply/ Money base = 1000/100 = 10
Money multiplier is the reciprocal of the reserve ratio
MONETARY POLICY AND
CENTRAL BANK
RBI preamble states its basic function as:
“ to regulate the issue of Bank notes and keeping of reserves with a view
to securing monetary stability in India and generally to operate the
currency and credit system of the country to its advantage; to have a
modern monetary policy framework to meet the challenge of an
increasingly complex economy, to maintain price stability while keeping
in mind the objective of growth.”
In modern economies, the creation of money is inextricably tied up with
the creation of credit, or the process of lending by commercial banks
whose actions are regulated by government and managed by the central
bank.
INSTRUMENTS OF MONETARY POLICY

1. Open market operations

2. Reserve requirements
3. Discount rate
OPEN MARKET OPERATIONS
If the central bank wants to increase the money supply in
the economy , it buys government bonds from the bond
market.

Central bank can buy the bonds in return for money,

which increases the total money in circulation. Some of
this money is held as cash and other as deposits in the
bank.

Every unit of money deposited increases the money

supply because it becomes part of the reserve
OPEN MARKET OPERATIONS
If the central bank wants to decrease the money supply
in the economy , it sells government bonds in the bond
market to the public.

The public pays for the government bonds through

cash and bank deposits therefore reducing the money
in circulation.

As people withdraw from the banks the reserves held

become smaller, and people reduce the amount of
lending also reversing the money creation process
RESERVE REQUIREMENTS
Reserve requirements influence how much money the banking
system can create with each unit of money of reserves.
An increase in reserve requirements means that banks must hold
more reserves and, therefore, can loan out less
 If central bank raises the reserve ratio, it will lower the money
multiplier, and decreases the money supply
 Conversely, a decrease in reserve requirements lowers the reserve
ratio, raises the money multiplier, and increases the money supply.
 DISCOUNT RATE
 If a bank falls short of having the required amount of reserves on hand,
it can borrow funds from the central bank at a rate of interest called the
discount rate.
 A higher discount rate discourages banks from borrowing reserves,
which in turn reduces the money supply
 A lower discount rate encourages bank borrowing, increases the
quantity of reserves, and increases the money supply
 INTEREST Interest rate determined in the private market for
overnight loans of reserves among banks
RATE

When the central bank makes an open market purchase of government bonds, it increases the
supply of reserves that can be lent on the government funds market, lowering the interest rate.
 INTEREST AND INVESTMENT
 Is interest rate the only aspect that investors pay attention to while
making decisions to invest?
 Investor confidence also plays a role. What is the mechanism?
Accelerator principle: the idea that high GDP growth leads to increasing
investment, and low or negative GDP growth leads to declining
investment
 All else being equal, intended investment is inversely related to the
interest rate, r.
INVESTMENT IN THE
ECONOMY
Interest and investment Investor confidence and investment
MONETARY POLICY AND AGGREGATE DEMAND

In an economy with low inflation and a stable banking system,

Expansionary
Lowers Investment is
monetary
interest rates encouraged
policy

Equilibrium
AD rises
GDP rises
EXPANSIONARY MONETARY POLICY AND THE AD CURVE

Expansionary monetary policy

lowers interest rates, raises
investment spending, and
raises aggregate demand,
income, and output
TRANSMISSION OF
MONETARY POLICY
LIQUIDITY TRAP AND
QUANTITATIVE EASING
•The central bank buys bonds and other financial assets: It creates additional base
money for this purpose.
•This raises demand for bonds and other financial assets: So the central bank
shifts the demand curve for those assets to the right, which pushes up the price.
This also decreases the yield and interest rate on bonds.
•This boosts spending: Particularly on housing and consumer durables, because
both the cost of borrowing and return to holding financial assets has gone down.
So, even when the interest rate the central bank directly controls is stuck at zero,
it can use QE to try to reduce the interest rate on a variety of other financial
assets.
QUANTITY THEORY OF MONEY: CLASSICAL ,
MONETARISTS AND KEYNESIANS

Quantity equation: M x V = P x Y
where,
M is money supply
V is velocity of money – no. Of times currency changes hands
P is Price level
Y is real output
Quantity theory of money: the theory that money supply is directly related
to nominal GDP
Monetary neutrality: the idea that changes in the money supply may affect
only prices, while leaving output unchanged