Money & Banking

UNIT 6: MONEY AND BANKING SYSTEM

Money – definition, functions, types, control of money supply – open market operations,
measures of money supply, high – powered money, money multiplier, Credit creation by
commercial banks, seigniorage and inflation tax

WHAT IS MONEY?

Money is a financial asset that is universally accepted as a means of payment in transactions and
settlement of debt. It does not need to be converted into something else before it can be used for
transactions. So it represents purchasing power in the most liquid form. So, money can be
defined as the stock of assets that can be readily used to make transactions.

WHAT ARE THE FUNCTIONS OF MONEY?

i) Medium of exchange

The most important function of money is that it acts as a means of payment. We can buy goods
and services using money. Without money, exchanges would have been extremely inconvenient
as it used to be in barter system. But with money, it becomes a lot easier as it is the most liquid
form of financial asset.

ii) Unit of account

Money acts as a unit of account as the values of goods and services are expressed in units of
money. In other words, prices are quoted and debts are recorded in terms of money. It is the
yardstick for measuring transactions. So it acts as an unit of account.

iii) Store of value

Wealth can be held in the form of money for future use. In other words, it can be used to transfer
purchasing power from the present to the future. For example, if a person earns Rs. 100 today, he
has the choice of spending it either today, or tomorrow or next week or next year. Thus, his
purchasing power can be transferred from the present to the future. But money is an imperfect
store of value. This is because, with change in prices over time, the purchasing power of money
today might not be same as it is in some future date, that is, if prices rise in future, then his
purchasing power of the money would fall.

TYPES OF MONEY

i) Commodity Money

When commodities with some intrinsic value are used as money, then it is known as commodity
money. The most common example of commodity money is gold. The country which uses gold
as money or paper money that is redeemable for gold is said to follow gold standard. Before the
late 19th century, gold standard was very common. But now the countries have shifted from
commodity money to fiat money.

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ii) Fiat Money

Fiat money is that type of money that does not have any intrinsic value but becomes money by
Government decree or fiat. Currency notes and coins are examples of fiat money.

MEASURES OF MONEY SUPPLY

The amount of money available in an economy is known as money supply. In case of commodity
money, the amount of the commodity available in the economy is a measure of money supply. In
case of fiat money, the supply of money is controlled by the Government. Due to legal
restrictions, the Government has monopoly over printing money. In some countries like India,
the Central Bank has been given the sole authority to control money supply.
In a modern economy, money usually consists of coins, currency notes and current/savings
deposits of commercial banks, time deposits or term deposits in commercial banks, savings and
other types of deposits in post offices.

Note:
i) Current/savings account deposits in commercial banks are also known as demand deposits as
the deposits are payable on demand through cheques or otherwise. These are also considered
as money as cheques drawn on such deposits are readily accepted in the settlement of
transactions or debt.

Other deposits have a fixed term on maturity and cannot be withdrawn on demand. They are
called time deposits or term deposits.

ii) There is a distinction between legal tender and non-legal tender or credit money. Coins
and currency notes are legal tender. They cannot be refused in settlement of payments of any
type. This is not true of non-legal tender money like demand deposits of banks. A payee may
choose not to accept a cheque drawn on demands deposit in a commercial bank.

Supply of money is a stock variable whose value can be measured at particular date. The Reserve
Bank of India publishes figures for four measures of money supply. These are also known as
monetary aggregates:

M0 =Currency in circulation + Banker’s deposits with RBI + Other Deposits with RBI

= Currency in the hands of the public + (Cash reserves of the banks held with
themselves +Cash reserves of the banks held with RBI) + Other Deposits with the RBI

M1 = Currency + Demand Deposits

M2 = M1 + Savings Deposits with Post Office Savings Banks

M3 = M1 + Net Time Deposits of Banks (inter-bank deposits are netted out)

M4 = M3 + Total Deposits with the Post Office (Excluding National Savings Certificates)

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NOTE :
i) Demand deposits of the public in banks do not include interbank deposits.
(When one bank holds deposits on behalf of another bank then they are known as Inter bank
deposits)
ii) M1 is called Narrow Money and M3 is known as Broad Money or Aggregate Monetary
Resources (AMR)
iii) M2 and M4 have been devised to accommodate post office deposits.

HIGH POWERED MONEY / MONETARY BASE (M0)

The monetary base of the economy is also known as reserve money or high powered money. It
is generally denoted by M0. It represents all the cash in the economy. It comprises of the
following:
i) Currency in the hands of the public
ii) Other deposits with the RBI
iii) Cash reserves of the banks held with themselves
iv) Cash reserves of the banks held with RBI

When we talk about money supply we usually refer to broad money supply or M3

THE MODEL OF MONEY MULTIPLIER

• In this model we consider M1 as the measure of money supply.

M1 = Currency in the hands of the public (C) + Demand Deposits (D).
In other words, M1 is Money Supply or Ms= C+D;

• The monetary base of the economy is denoted by M0.

M0 = Currency (C) + Reserves (R)
In other words, M0 is High Powered Money or H = C+R;

Reserve (R) is the stock of Commercial Banks that they hold or they do not utilize to full lending
potential. It keeps certain portion of deposits aside to meet the customer’s daily need for cash,
some interbank transactions and for managing situations like bank failure.

Reserve (R) = Required Reserves + Excess Reserves

i. Required Reserve: Required reserves are those that the commercial banks need to
hold statutorily with central bank.
ii. Excess Reserve: If commercial banks hold more than require reserve, then it is
known s excess reserve.
• In an economy the Central Bank has exclusive control over the money stock through it’s
control over High Powered Money. If the central Bank increased the required reserve
then, the lending potential of the commercial banks will go down. Accordingly,
economy’s money stock will decrease.
• C →Printing new currencies, change in the circulation of amount of money stock;

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• Central bank can also change the amount of circulation of the amount of money stock
through Open Market Operations. It refers to the purchase or sale of govt. bonds by
central bank to the public.

Open Market Sale of Govt. Bonds by Central Bank to Public → Currencies flow more
to central bank from public →Circulation of money stock decreases →Money Supply in
the economy decreases;

Open Market Purchase of Govt. Bonds by Central Bank from Public → Currencies
flow more from central bank to public →Circulation of money stock increases →Money
Supply in the economy increases;

In an Open Economy, it’s money stock and high powered money are interrelated with money
multiplier ‘m’. The Money multiplier is basically the ratio between the economy’s money supply
𝑀 𝑀 𝐶+𝐷
to high powered money. 𝑚 = 𝐻𝑠 = 𝑀1 = 𝐶+𝑅 →𝑀𝑠 = 𝑚𝐻
0

We can represent the link between money stock and high powered money using the following diagram
known as Money Pyramid.

We can represent the interlink money stock and high powered money diagrammatically which is
𝑀 𝐶+𝐷
known as Money Pyramid of the economy. 𝑚 = 𝐻𝑠 = 𝐶+𝑅

The purpose of the model of money multiplier is to show how the Monetary Base, Currency-
Deposit ratio and the Reserve-Deposit ratio together determine the money supply of the
economy.

• In this model we consider M1 as the measure of money supply.

M1 = Currency in the hands of the public (C) + Demand Deposits (D).
Or, Ms= C+D;
• The monetary base of the economy is denoted by M0.
M0 = Currency (C) + Reserves (R)
Or, H = C+R;
𝐶
• The currency-deposit ratio is denoted by α (where α = 𝐷 ).
This shows the fraction of deposits that people hold as currency. It represents the
preference of the households regarding the type of money they wish to hold.

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𝑅
• The reserve-deposit ratio is denoted by β (where β = 𝐷 ).
This shows the fraction of deposits that is held as reserves. This depends on the laws
regulating banks as well as the business policy of the banks.
M1 = C + D …………………… (I)
M0 = C + R …………………… (II)

𝑀1 𝐶+𝐷
Step I: Dividing (I) by (II) we get: =
𝑀0 𝐶+𝑅

Step II: Dividing the numerator and denominator of R.H.S by D, we get:

𝐶
𝑀1 𝑀𝑆 +1 𝛼+1
𝐷
= = 𝐶 𝑅 =
𝑀0 𝐻 + 𝛼+𝛽
𝐷 𝐷

𝛼+1
Or, 𝑀1 = × 𝑀0
𝛼+𝛽
𝛼+1
Or, 𝑀𝑆 = ×𝐻
𝛼+𝛽
Or, 𝑀1 = 𝑚 × 𝑀0 or, 𝑀𝑆 = 𝑚 × 𝐻
𝛼+1
where m” represents Money Multiplier and 𝑚 = 𝛼+𝛽
𝐶 𝑅
Here, currency-deposit ratio = α = 𝐷 & reserve-deposit ratio = β = 𝐷;
𝑅1 𝑅2 𝑅 𝑅1 𝑅2
Reserve Deposit Ratio β has two components. & ; i.e. 𝛽 = 𝐷 = +
𝐷 𝐷 𝐷 𝐷
𝑅1 𝑅2
𝛽1 𝑜𝑟 is the Required reserve ratio and & 𝛽2 𝑜𝑟 is the Excess reserve ratio;
𝐷 𝐷
𝛼+1
Now, 𝑀𝑆 = 𝑚 × 𝐻; 𝑀𝑆 = 𝛼+𝛽 × 𝐻 ---- (1)

From equation (1), let us now focus on the determinants of 𝑴𝑺 :

(i) The High Powered Money or Monetary Base or H or 𝑴𝟎 :

M0 or H and M1 or Ms are directly related. As H rises, 𝑀𝑆 rises; If M0 rises by 1 unit, then M1
rises by “m” units. Therefore the monetary base has a multiplied effect on money supply.
Hence the monetary base is also known as High powered money. [H↑ 𝑀𝑆 ↑]
𝑪
(ii) Currency-deposit ratio = α = 𝑫:
The Currency Deposit Ratio depends on the payment habits of people. The lesser the amount
of cash people are holding, lesser will be α, which causes money circulation to rise.
Accordingly, it will boost the money multiplier and thereby 𝑀𝑆 will rise.
If the currency-deposit ratio or α rises, then M1 or Ms will fall. [α↑ 𝑀𝑆 ↑]

[If α rises, (α+ 1) will rise as well as (α + β) will rise.

As β is a fraction, i.e β< 1, So (α+ 1) > (α + β)
So, proportional rise in (α + β) will be relatively more than (α+ 1) for the same rise in α.
Since proportional rise in numerator is relatively less than proportional rise in denominator,
so the fraction will fall. Hence m will fall and so M1 will also fall with rise in α.]

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(iii) If the reserve-deposit ratio or β rises, then Ms will fall.

𝛼+1
[If β rises, (α + β) will rise, and hence will fall, i.e. m will fall and so 𝑀𝑆 will fall.]
𝛼+𝛽

a. If 𝜷𝟏 i.e. Cash Reserve Ratio rises →it causes the lending capacity of commercial
banks to decrease. Accordingly 𝑀𝑆 will also reduce.
[𝛽1 ↑ 𝑚 ↓ 𝑀𝑆 ↓]

b. 𝜷𝟐 = 𝒇(𝒓𝒎 , 𝒓𝒅 ) where, 𝑟𝑚 =market interest rate and 𝑟𝑑 = repo rate or discount rate;

i. 𝒓𝒎 or market rate of interest represents the opportunity cost of holding

excess reserve. If it increases, accordingly it will boost up the money
multiplier m.
[𝑟𝑚 ↑ 𝛽2 ↓ 𝑚 ↑ 𝑀𝑆 ↑]

ii. 𝒓𝒅 or repo rate or discount rate is the rate at which commercial banks
borrow from central bank of the country. As central bank increases the
repo rate 𝑟𝑑 , it causes commercial banks to hold greater amount of excess
reserve. Accordingly, money multiplier falls. Hence, money supply falls.
[𝑟𝑑 ↑ 𝛽2 ↑ 𝑚 ↓ 𝑀𝑆 ↓]

CREDIT CREATION BY COMMERCIAL BANKS

Money multiplier basically represents the lending potential of the entire banking system. In other
words, it is the total money stock generated by all the banking system (commercial bank)
together, if central bank increases the high powered money by one additional unit. For this
purpose, let us now focus on the balance sheet of the commercial bank and the central bank.

Commercial Bank Central Bank

Assets Liabilities Assets Liabilities
Reserves (R) Deposit (D) Domestic Credit (DC) Currency (C) High
Loan (L) Foreign Exchange Reserve Reserve (R)
(FOREX)
} Powered
Money (H)

According to the accounting principle,

For Commercial Banks: D=L+R

and for Central Bank: H = DC + FOREX

The model of credit creation shows how commercial banks can affect money supply.
Let us consider M1 = Currency(C) + Demand Deposits (D) as the measure of money supply.

Given this, let us consider the following example.

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Assumption 1: An economy without banks.

In this case the total money supply is equal to the total currency in the hands of the public,
because there are no banks and so demand deposits = 0.
If 1000 units of currency are circulated, then volume of money supply is equal to 1000 units.
M1 = C + D = 1000 + 0 = 1000 units. Hence, α = 0;

Assumption 2: An economy with commercial banks with 100% reserve banking.

Here we assume that people keep money in banks because banks are a safe custody for keeping
money but banks do not advance deposits or loans. The total money deposited is kept as reserve
in the banks. So it is called 100% reserve banking. Here the banks do not earn any profit but they
charge nominal fees for maintaining the accounts. So a person having units of currency keeps it
in banks and the bank keeps the deposits as reserve until the person draws a cheque to withdraw
the deposit.

Suppose there are 1000 units of currency in the economy and people holding the currency keeps
it in banks. Here also the total money supply is 1000 units. Here M1 = C + D = 0 + 1000 = 1000.
The balance sheet of the bank can be represented as follows:
Assets Liabilities
Reserves = 1000 Deposits = 1000
In both these cases, the money supply is same as the units of money that was initially available,
that is 1000 units. That is, no credit was created.

Assumption 3: Economy with commercial banks under fractional reserve banking

Here, under fractional reserve banking, the banks accept the deposits from the public and keeps a
fraction of it as reserves and advances the rest of the money as loans. In this case, the
commercial banks will be able to affect money supply.

Let us take one example.

(iv) Suppose the total currency in the hands of the public be 1000 units.
(v) Let us assume that the banks keep 20% as reserve and advances the rest 80% as loans.
(vi) Suppose person A deposits 1000 units of currency in bank 1. The bank keeps 20% i.e 200
units as reserve and advances the rest 80% i.e. 800 units as loans to person B.
(vii) Person B deposits 800 units in Bank 2. Bank 2 keeps 20%, i.e. 160 units as reserve and
advances 80% i.e. 640 units as loans to person C.
(viii) Person C deposits 640 units in bank 3 which keeps 20% i.e. 128 units as reserve and
advances 80% i.e. 512 units as loans.
(ix) This process will continue. The balance sheet of the three banks can be shown as follows:

Bank 1 Bank 2 Bank 3

Assets Liabilities Assets Liabilities Assets Liabilities
Reserves 200 Deposit 1000 Reserves 160 Deposit 800 Reserves 128 Deposit 640
Loan 800 Loan 640 Loan 512

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Let us try to understand how banks manage to create credit.

Initial money supply = 1000 units
In the next step,
Money supply = 1000 units + 800 units
20
= 1000 + (1 − 100) × 1000 = 1000 + (1 – β) ×1000.
[β = reserve ratio which denotes the fraction of deposits that bank hold as reserves ]

In the next step,

Money supply = 1000 units + 800 units + 640 units
20 20
= 1000 + (1 − 100) × 1000 ++(1 − 100)2 × 1000
= 1000 + (1 – β) × 1000 + (1 – β)2 × 1000
In the next step,
Money supply = 1000 units + 800 units + 640 units + 512 units
20 20 20
= 1000 + (1 − 100) × 1000 ++(1 − 100)2 × 1000+(1 − 100)3 × 1000
= 1000 + (1 – β) × 1000 + (1 – β)2 × 1000 +(1 – β)3 × 1000
This process will continue.
Therefore total money supply = M1 + (1 – β) × M1 + (1 – β)2 × M1 +(1 – β)3 × M1 +……..
1
= M1 [1+ (1 – β) + (1 – β)2 +(1 – β)3 +……..] = M1 × ( 𝛽 )
Therefore total money supply =1000[1+(1 – β) + (1 – β)2 +(1 – β)3 +…..]
1 1
=1000×𝛽 =1000×0.2 = 5000
1
Where [1+ (1 – β) + (1 – β)2 +(1 – β)3 +……..] =𝛽; which is the sum of the infinite G.P series.
Therefore initial 1000 rupees of increase in money stock will eventually generate money stock of
Rs.5000 in the economy. This shows that Money supply will increase 5 times if central bank
increases high powered money.

Thus commercial banks can affect the money supply of the economy. Of all financial institutions
only banks have the legal authority to create assets that are part of money supply. Again it is to
be noted that banks create money and not wealth. In other words, the creation of money by the
banking system increases the economy’s liquidity and not its wealth.

HOW CENTRAL BANK CONTROLS THE MONEY SUPPLY?

The control over the supply of money by the central bank or the government is known as
monetary policy.
The central bank controls the money supply to attain the following goals:
i) High and stable employment
ii) Economic growth
iii) Price stability
iv) Financial stability
v) Stability in the foreign exchange market

Some of the goals are consistent with one another whereas others might be conflicting. For
example high economic growth might lead to high employment but again low inflation might

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lead to rise in unemployment. So central bank has to face various trade-offs in order to make the
right choice of the policies.

The monetary policy targets are generally classified as

i) Ultimate targets
ii) Intermediate targets
The ultimate targets that the monetary authority attempts to control are major macroeconomic
variables such as unemployment, inflation and growth of real GDP. But it is not possible for
the RBI to act on the ultimate targets directly. Therefore it often chooses to control intermediate
targets which are not important in their own right, but help in influencing the ultimate goals in a
predictable way. Important intermediate targets are the monetary aggregates
(𝑴𝟎 , 𝑴𝟏 , 𝑴𝟐 , 𝑴𝟑 , 𝑴𝟒 ) or the interest rates.

Generally, at the beginning of each quarter, the RBI determines the Money Growth Rate that
seems consistent with achieving the ultimate targets. This money growth rates and ultimate
targets are determined on the basis of data on past performance and forecasts about the next
quarter or year made by a team of analysts. Accordingly, the RBI decides on using the various
monetary policy instruments. Again in the beginning of the next quarter, the money supply target
is reviewed and adjusted on the basis of the experience within the quarter.

The RBI can affect the money supply by changing the Monetary base or the value of the money
multiplier. This can be done through various monetary policy instruments.
Three major instruments are :
i) Variation in CRR
ii) Variation in Bank Rate
iii) Open market operations

i) Variation in CRR
If the bank raises the CRR ( the reserves of commercial banks held at RBI ), the loanable funds
at the disposal of commercial banks gets reduces at one stroke and the money supply contracts.
The opposite effect happens when CRR is reduced. Changing the CRR is a drastic way of
changing the money multiplier and it is not used very frequently as frequent changing of CRR
might lead to destabilizing of the system.
ii) Variation in the Bank Rate
Commercial banks may approach the RBI for loans to add to their reserves. The bank rate is the
interest rate charged by the bank for such loans. If the bank rate is low, the banks are encouraged
to borrow reserves against which they can advance loans. This facilitates credit creation. If the
bank rate is high, banks are discouraged to borrow from RBI. Moreover, with rise in bank rate,
the banks also raise the rates of interest they charge on their loans. This diminishes the demand
for credit by firms or households.
iii) Open Market Operations
Open market operations refer to the sale and purchase of Government Bonds. When Central
Bank wants to increase money supply, it purchases Government bonds from the public and then
the currency available in the hand of the public increases. When it wants to decrease money
supply, its sells Government bonds from its own portfolio, and thus the currency in circulation
decreases.

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Prove that, Money multiplier is the total amount of money stock generated by the banking
system together if the central bank increases high powered money by Rs. 1.

Let us consider that, central bank increases high powered money by one unit through open
market operation (purchase). Individuals of the economy will receive additional 1 unit of money
stock.
A certain proportion of this additional money stock will be held by the people in the form of
currency and the rest will be deposited in a commercial bank.

We have, 𝑀𝑆 = 𝐶 + 𝐷 →∆𝑀𝑆 = ∆𝐶 + ∆𝐷 →∆𝐶 + ∆𝐷 = 1 ------ (1)

𝐶
We also have, 𝛼 = 𝐷 →𝐶 = 𝛼𝐷 →∆𝐶 = 𝛼∆𝐷 --------- (2)
1
Substituting (2) in (1) we get, 𝛼∆𝐷 + ∆𝐷 =1 → ∆𝐷 =
1+𝛼
1
So, commercial bank deposit will increase by 1+𝛼
Accounting principle of commercial bank suggests that,
𝑅 + 𝐿 = 𝐷------- (3)
∆𝑅 + ∆𝐿 = ∆𝐷------ (4)
𝑅
𝛽=𝐷 →𝑅 = 𝛽𝐷 →∆𝑅 = 𝛽∆𝐷 ------ (5)
1−𝛽
Substituting (5) in (4) we get, 𝛽∆𝐷 + ∆𝐿 = ∆𝐷 →∆𝐷(1 − 𝛽) = ∆𝐿 →∆𝐿 = 1+𝛼
1−𝛽
Therefore, additional loan to be provided by the commercial banks will increase by (1+𝛼)
1−𝛽
Accordingly, in the 2nd round money supply will increase by (1+𝛼 )amount.
1−𝛽
Let us assume 𝑥 = ( )
1+𝛼
The people in the economy will receive this additional 𝑥 unit of money. A certain proportion of
this will be held as cash and the rest will be deposited in commercial banks.
∆𝐶 + ∆𝐷 = 𝑥
𝑥
Substituting (2) we get, 𝛼∆𝐷 + ∆𝐷 = 𝑥 → ∆𝐷 = 1+𝛼
𝑥
Therefore, in the 3rd round, commercial bank deposits will increase by (1+𝛼) amount.
Again by accounting principle of commercial banks we have, ∆𝑅 + ∆𝐿 = ∆𝐷
Substituting (5) we get,
𝑥 1−𝛽 2
𝛽∆𝐷 + ∆𝐿 = ∆𝐷 →∆𝐷(1 − 𝛽) = ∆𝐿 →∆𝐿 = (1 − 𝛽) 1+𝛼 = (1+𝛼)
1−𝛽
Therefore in the 3rd round, commercial banks will produce additional loan of (1+𝛼)and
1−𝛽 2
accordingly in the 3rd round total increase in money supply will be(1+𝛼 ) .

Again a certain proportion of this money supply will be help by public and the rest will be
deposited in a commercial bank. Accordingly, loan will be provided by the commercial banks.

Hence in the 4th round, money supply will increase by the same procedure. This is basically an
infinite process of expansion of money supply generated by banking system together.

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So, we get the following infinite series of expansion of money supply in the economy generated
by the banking sector together.
1−𝛽 1−𝛽 2 1−𝛽 2 1−𝛽 2
[1 + ( )+( ) +( ) +( ) +⋯]
1+𝛼 1+𝛼 1+𝛼 1+𝛼
1
=[ 1−𝛽 ]
1−(1+𝛼)

1
=[ 1+𝛼−1+𝛽 ]
( 1+𝛼 )
1+𝛼
=(
𝛼+𝛽
)=𝑚
Hence proved.

SEIGNIORAGE AND INFLATION TAX

The Government can finance its expenditure in three possible ways:

(x) Raising tax revenue
(xi) Borrowing from the public by selling Government bonds
(xii) Printing new money

The revenue from printing new money is known as Seigniorage. When new money is printed
and circulated in the economy, the money supply of the economy rises. With the rise in money
supply, the general price level of the economy rises (inflation). With rise in the general price
levels, the purchasing power of money held by public falls. This fall in the purchasing power of
money held by the public can be viewed as a tax that the holders of currency are paying due to
inflation caused by printing new money. This is not tax paid in the real sense but it is implicit
tax, as the purchasing power of the money held is falling. So seigniorage is also known as
inflation tax.

We know that, the money market equilibrium condition is given by,

𝑀
= 𝐿(𝑦, 𝑖)
𝑃
𝑀
Or, 𝑃 = 𝐿(𝑦, 𝑟 + 𝜋) ---- (1)
Let R be the seigniorage revenue received by the govt. This revenue equals to the additional
money stock generated by the govt. through printing new money in real terms.

Let ∆M be the volume of new money that is printed and circulated in the economy. So the
∆𝑀
nominal seigniorage revenue is ∆M. But the real seigniorage revenue, 𝑅 = 𝑃
Let M0 be the initial stock of money in the economy.
∆𝑀 ∆𝑀 𝑀0 ∆𝑀 𝑀0 𝑀0
𝑅= = × = × [since = 1]
𝑃 𝑃 𝑀0 𝑀0 𝑃 𝑀0

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∆𝑀 𝑀0
So real seigniorage revenue depends on and .
𝑀0 𝑃
∆𝑀 𝑀
Where represents growth of money stock of the economy and represents the purchasing
𝑀0 𝑃
power of old money stock.
∆𝑀
Let us consider, = 𝑔𝑚 or money growth
𝑀0
From the quantity theory of money, we have 𝑔𝑚 = 𝜋
𝑀 𝑀
Hence, 𝑅 = 𝑔𝑚 𝑃 = 𝜋 𝑃 ------ (2)
Therefore, seigniorage revenue equals to the money growth multiplied by economy’s real money
balance.
When Govt. prints money, inflation or π increases. [π↑]
𝑀 𝑀
Now as prices increase, falls. Hence real value of existing money stock falls. [𝑃 ↑ ℎ𝑒𝑛𝑐𝑒 𝑃 ↓]
𝑃
As money supply rises, ∆M > 0. So ∆M/M0 is positive. With rise in money supply, P will rise
and hence M0/P will fall. So the purchasing power of old money stock will fall. This is why
seigniorage is known as Inflation tax.
∆𝑀 𝑀0
Note: If > then R will rise.
𝑀0 𝑃
∆𝑀 𝑀0
If = then R will remain same
𝑀0 𝑃
∆𝑀 𝑀0
If < then R will fall.
𝑀0 𝑃
𝑀
It seems to be like an imposition of tax on old money supply. Where, 𝑅 = 𝜋
𝑃

Therefore, printing new money makes the old money in the hands of people less valuable.
Printing money is basically an imposition of taxes on old money stock that people are holding.
𝑀
Accordingly, inflation rate (π) is the tax rate and existing real money balance is the tax base.
𝑃
Printing of money is redefined as inflation tax on people.

Let us now discuss the relationship between seigniorage revenue, money growth and inflation.
As Govt. prints new money, there will be two opposite impacts on seigniorage revenue (R)
simultaneously.
𝑀
From equation (2), 𝑅 = 𝜋 = 𝜋 × 𝐿(𝑦, 𝑟 + 𝜋)
𝑃
If, 𝑀𝑆 ↑ → 𝜋 ↑ → 𝑅 ↑ ----------------- [i]
and If, 𝜋 ↑ → 𝑖 ↑ from Fisher’s equation 𝑖 = 𝑟 + 𝜋;
→ Opportunity cost of holding money↑
→ People’s demand for real money balance↓ → 𝑅 ↑ -----------------[ii]

The exact impact depends on relative strength of these two impacts i.e. whether the rise in
inflation dominates the fall in the demand for real money balance.

St. Xavier’s College (Autonomous), Kolkata Page 12

 Money & Banking

Basically at initial level of money growth, rise in inflation dominates the fall in demand for real
money balance so that seigniorage revenue increases. Beyond a particular level of money
growth, seigniorage revenue reaches maximum. Here R increases exactly at the rate of money
∗
growth. Above that level, (i.e. after 𝑔𝑚 ), seigniorage revenue R starts falling.

REFERENCES / SUGGESTED READS :

1) Macroeconomics by N. Gregory Mankiw ; 6th edition , Worth publishers
2) Principles of Macroeconomics by Soumyen Sikdar ; 2nd edition, OUP
3) Macroeconomic Policy Environment - An Analytical Guide for Managers; 2nd edition,
TMH

QUESTIONS:
1) What is money?
2) Is money same as income?
3) What are the functions of money?
4) What are the types of money?
5) What is reserve money or high powered money?
6) Explain the model of money multiplier.
7) Explain the process of credit creation by commercial banks?
8) What is seigniorage? Why is it known as inflation tax?
9) Explain the various ways by which the government can control the money supply of the
economy.
10) Briefly describe the measures of money supply used in India. In this context identify the
narrow measure and the broad measure of money supply.

St. Xavier’s College (Autonomous), Kolkata Page 13