EEP-7 Money and Banking Prof.tarun Das

8/9/2019 EEP-7 Money and Banking Prof.tarun Das

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Prof. Tarun Das, IILM EEP-8 Inflation, Money, Banking 1

Economic Environment and PolicySession-7

Inflation, Money and Banking

Presented by

Dr. Tarun Das, Professor, IILMFormerly, Economic Adviser, Ministry of Finance


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Contents

1. Money Supply and Role of RBI2. IS and LM curves

3. Monetary and Banking Reforms4. Different Inflation Rates5. Anti Inflationary Policies


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1.1 Functions of Money

Money comprises currency and transferable

deposits which are the most liquid financialassets. Money has four basic functions:a) Medium of exchange the means for

acquiring goods, services, and financial andnonfinancial assets without barter trade;

b) Store of value a means of holding wealth;c) Unit of account a standard for

denominating the prices of goods andservices and the values of financial andnonfinancial assets; keeping accounts;

d) Standard for deferred payment a meansof relating current and future values andaccounts in financial contracts.


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1.2Characteristics of Money

a) Legal tenderb) General acceptability.c) Fixed nominal (face) value.d) Easy Transferability.e) Divisibility.f) Maturity.g) No appreciation

h) No Depreciationi) No Transaction costs.

j) No Yield.


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1.3 Demand and Supply for Money

Real demand for money depends on: real income (real GDP) opportunity cost of holding money (real

interest rate) Money demand (Md) function looks like:

+ -Md = f (Y/P, r) where Y = Nominal GDP

and P = WPI or GDP Deflatorand r = real interest rate

And on the supply side:Ms = P.T where P = average price, and

T = total transactions


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1.5Narrow Money and Broad Money

A. From supply side, Narrow Money is defined ascurrency and notes with the public, pluscurrent deposits which are completely liquid.

B. From supply side, Broad Money includes termdeposits in addition to narrow money.

C. Broad-money holders Central government State and local government Central Bank and Commercial Banks Nonfinancial corporations

Other resident sectors Non-residents holding national currency


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1.6 Money Supply and Demand in India

ReserveMoney(M0) =Supply

Currency in circulation+ Bankers deposits with the RBI+ Other deposits with the RBI

(M0) =

Demand

Net RBI credit to the Government

+ RBI credit to the commercial sector+ RBIs claims on banks+ RBIs net foreign assets+ Govts currency liabilities to the public

RBIs net non-monetary liabilities

M1 =NarrowMoney

Currency with the public+ Demand deposits with banking system+ Other deposits with the RBI.


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1.7 Money Supply and Demand in India

M3 =BroadMoney

M1 + Time deposits with the banks=Currency with the public+ Demand and time deposits with banks+ Other deposits with the RBI.

M

3 =BroadMoneyDemand

Net bank credit to the Govt + Bank creditto commercial sector + Net foreign assetsof the banks + Govts currency liabilitiesto the public Net non-monetaryliabilities of the banking sector

M4 =Broader/WiderMoney

M3 + All deposits with post office savingsbanks (excluding National SavingsCertificates).


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1.8 Some Basic Concepts

Income Velocity of Money

= GDP at current market prices/ Broad Money

Supply = GDP / M3

Money Multiplier = Broad Money Supply/

Reserve Money = M3/ M0


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1.9 Money supply during one yearending 24 Oct 2008(Rs. Bln)

Amount GR%7,210 19.9

(i) Currency with the Public 1049 20.7

(ii) Demand Deposits 650 14.3

(iii Time Deposits with Banks 5510 20.8(iv) "Other" Deposits with RBI 1 2.6

7210 19.9

(i) Net Bank Credit to govt 1320 15.5

(ii) Bank Credit to private sect 6033 27.0(iii Net Foreign Exchange 2419 22.7

(iv) Govt's Currency liability 8.0 8.7

(v) Net Non-Monetary liability 2570 47.1

M3 Demand= (i+ii+iii+iv-v)

Com onents of Mone Su lM3 Su l i + ii + iii + iv


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2.1 Equilibrium in Goods & Money Markets

I = I(r), S=S(Y), I=SIS curve is the locus of all points (r,Y)

where S=IMD=Demand of Money=Mt + MsMt=Transactions demand for money= Mt(Y)

Ms=Speculative demand for money= Mt(r)Equilibrium conditionMt + Ms= MSo = Exogenous supply of money.LM curve is the locus of points (r,Y) at

wh

ich

demand for money equals supplyof money.General Equilibrium level of (ro,Yo) exists where

IS curve passes through the LM curve.


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2.2 IS Curve

I = I(r), S=S(Y), I=S

IS curve is the locus of all points (r,Y) where S=Ir

YI

S

IS Curve

I = I(r)

I=SS=S(Y)


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2.3 LM Curve

MD=Mt(Y)+Ms(r), MD=MS; LM curve is the locus

of all points (r,Y) where MD=MS.r

YMs

Mt

LM Curve

Ms= Ms(r)

MSo=Mt+Ms

Mt=Mt(Y)


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2.4 Equilibrium Level (ro,Yo)

Y

r LM

IS

(ro,Yo)

O


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3.1 Financial corporations sector

1. Central Bank (Reserve Bank of India)

2.O

ther DepositoryC

orporations3. Other Financial Corporations

Insurance Corporations & Pension Funds

Other Financial Intermediaries

Financial Auxiliaries


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3.2 Depository corporations

All resident financial corporations and quasi-corporations that are mainly engaged infinancial intermediation and that issue

liabilities included in the national definitionof broad money

Comprise two subsectors:

- Central bank

- Other depository corporations (ODCs)


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3.3 Main Functions of the Central Bank

a) Banker to the government

b) Banker to the commercial banks

c) Currency issue and money supply

d) Issue of govt securitiese) Monetary Regulatory Authority

f) Monetary policies to promote growth andcontrol inflation

g) International reserves managementh) Transactions with IMF

i) Lender of last resort


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3.4 Other Financial Corporations

a)Commercial banks

b) Savings banks,

c) Savings and credit associations,

d)Credit unions, credit cooperatives

e) Building societies

f) Finance companies


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3.5 Functions of Financial Corporations

Provide financial intermediation forsavers and investors,

Primary creators of deposit money, by

extending credit Their actions, particularly their policieson deposit taking and lending, affectmoney supply and liquidity

Operate within the constraints set bythe central monetary authority,

commercial banks help to implementmonetary policy


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3.6 Financial Sector Reforms

Status in June 1991

Indian firms not

allowed to raise funds

from foreign stock

exchanges Portfolio investment

by foreign investors in

Indian companies not

allowed Foreigners not

allowed to buy G-secs

Status in Nov 2008 Indian firms allowed to

raise foreign funds by

GDR, ADR, FCCBs &

offshore funds FIIs, NRIs and OCBs

allowed to buy stocks

in Indian markets s.t.

overall limit of 74% FIIs/ NRIs/ OCBs

allowed to buy G-secs


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3.7 Financial Reforms

Status in June 1991 CRR 25%

SLR 38.5%

Bank Rate 12%

PLR above 21%

Deposit and interest

rates are controlled

Capital issues andprices determined by

the CCI in MOF

Status in Dec 2008

CRR 5.5%

SLR 25%

Bank rate 6%

PLR 11% to 11.5%

Deposit and interest

rates are liberalised

The office of CCIabolished and SEBI

established


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4.1 Inflation Rates Most of the developed countries prepare

Producers Price Index (PPI) whichmeasures the average production cost ofgoods and services produced.

India does not have any PPI. India measures inflation by Wholesale

Price Index (WPI) and Consumers PriceIndex (CPI).

WPI considers primary and manufacturedgoods, but does not include services.

CPI considers goods and services used bythe consumers.

So both WPI and CPI are partial priceindices.


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4.2 Inflation Rates

The wholesale price index (WPI), publishedevery week, is the most widely monitoredindicator of headline inflation.

It suffers from the obvious limitation ofbeing confined to commodities only, and

not considering services which constitutemore than 55% of GDP. The best indicator of inflation over the

years may be the implicit GDP deflator. But, it is only available for annual and

quarterly data and that too withconsiderable time lags.


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4.3Consumer Price Index (CPI)

Despite recommendations of several expertcommittees, India does not yet have anation-wide consumer price index (CPI).

It has four separate CPI indices fordifferent categories viz. industrial

workers, non-manual urbanemployees, agricultural labor andrural labor.

Of these, the CPI for industrial workers,CPI (IW), is the most commonly used

index for determination of dearnessallowances in both public and privatesectors.


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4.4 Trends of Inflation in India

a)Inflation has been in the comfort zoneof around 5% since 1998/9.b)WPI inflation or five-year averages of any

index, has been subdued since 1996/97.c) During the last ten years, the GDP

deflator has averaged just over 4 percent,d)Even in 2007/8 and despite the globalcommodity price shock, the annual rateon inflation reflected by the GDP deflatorwas only 4.1.

e)Currently, both CPI and WPI runningaround 8 per cent.


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4.5 Anti-inflationary Measures

a)Inflation is of two types cost pushed and

demand pulled. Inflation can also beimported due to hardening of global pricesof crude oil and manufactured goods.

b)Demand pulled inflation can be tacked bycontractionary policies i.e, increasing

interest rates, bank rate and CRR, andincreasing the excise duties. However,govt may reduce customs duties toencourage imports for meeting demand.

c)Cost pushed inflation needs expansionary

policies i.e. reducing interest rates, bankrate and CRR, and also reducing exciseand customs duties on essential goods.

d) Along with fiscal and monetary measures,govt also needs real policies.


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THANK YOU

Have a Good Day

EEP-7 Money and Banking Prof.tarun Das

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