Money and Monetary Policy

Introduction
In chapter tells the importance of money in the economy. This chapter briefly tells how
money market works in the macroeconomy. This chapter also discusses the forces that
determine the supply of money and show how banks create credit. Finally,how money
supply is controlled by monetary policy through its targets and instruments was
discussed.
Money
Money can be referred to as one of the greatest innovations of the human society. It is a
simple concept that we understand but it is rarely difficult to define. Different economists
gave different definition of money. Money is the set of assets in an economy that people
regularly use to buy goods and services from others. Normally, money is anything
serving as a medium of exchange. Most definitions of money take ‘functions of money’
as their starting point. Money is needed to mediate transactions. It has purchasing
power which enables us for exchanging goods and services. So this makes money a
unique commodity. Besides this money is the commonly used means of transferring
purchasing power. It can be used for settlement of debt.
Functions of Money:
In all money serves three important functions for any society: Medium of Exchange,
Store of Value, and Unit of Account.
1. Medium of Exchange:
This is the central function of money. If there is no money; then goods and
services have to exchange for other goods; which is called as barter system. The
major problem in the barter system is that each transaction requires a double
coincidence of wants. It is very difficult for the owner of some goods and services
to find someone else who wants both his goods and services and posses those
goods and services that our trader wants.
Money; as a medium of exchange; eliminates the problem of double coincidence
of want. It acts as intermediary. People can sell their output for money and also
they use money to buy goods and services. Thus, money facilitates the sale and
purchase independent of each other.
2. Store of Value:
Money is a convenient way to store purchasing power; goods and services
maybe sold today, and money is taken in exchange for them stored until it is
needed. Therefore, people can use money to transfer their purchasing power
from the present to the future.
Money has stable value. An increase in the prices leads to decrease in the
purchasing power of money. Hence, person needs more money to buy goods
and services. Purchasing power of money remains stable if prices of goods and
services remain stable. But when price level is highly variable then usefulness of
money as a store of value is undermined.
3. Unit of Account:
Money serves as unit of account. According to Geoffrey Crowther, “Money acts
as a standard measure of value to which all other things can be compared.” It is
a standard unit that provides a consistent way of quoting prices. All prices are
quoted in monetary units.
 A related function of money is that it can be used as standard of deferred
payments. Payments that are to be made in the future, on account of debts are
calculated in money.
Commodity Money and Fiat Money
Full bodied money or Commodity money is made of metal like gold and silver and its
face value is equal to intrinsic value. On the other hand, Fiat money or token money is
money that is intrinsically worthless.
Money Supply
Money supply refers to the stock of money held by the public or those who demand
money at a point of time. The word public includes private individuals and the business
firms. It excludes government, Central Bank and commercial banks. In other words,
money supply is the stock of money in circulation. There are two components of money
supply are (i) Currency (ii) Demand deposits of commercial banks.

1. Currency: It consists of coin and paper currency.

a) Coins: Coins are issued by the monetary authority of the Country i.e, Central
Bank, and these coins are made up of metal.

Measures of Money Supply (money stock)

There are two most measures of money are transactions money, M 1, and broad money
M2.

1. Transaction money M1: It includes currency , demand deposits and other

deposits.
M1 = C +DD +OD
Here C denotes currency (paper notes and coins) held by public, DD stands
for demand deposits in banks and OD stands for other deposits. Demand
deposits are deposits which can be withdrawn at any time by the account
holders. Current account deposits are included in demand deposits. M 1 is a
stock variable.
2. Broad Money M2: M2 = M1 + saving deposits with Post Office Saving Banks
3. M3= M1 + Net Time-deposits of Banks
4. M4 = M3 + Total deposits with Post Office Saving Organisation (excluding NSC)
There is a debate on what constitutes money supply. Savings deposits of post
offices are not a part of money supply because they do not serve as medium of
exchange due to lack of cheque facility. On the other hand, fixed deposits with
commercial banks are not treated as money. Therefore, M1 and M2 may be
treated as measures of narrow money whereas M 3 and M4 as measures of broad
money.
M1 is commonly used as measure of money supply. All the four measures of
money supply represents different degrees of liquidity, with M 1 being the most
liquid and M4 is being the least liquid (liquidity means ability to convert an asset
into money quickly and without loss of value).
Sources of Money Supply:
 1. Government: Government issues one-rupee notes and all other coins and also
affects money supply through its fiscal measures like taxation, government
expenditure or borrowing. Collection of taxes from individuals or firms reduces
money supply in the economy. Whereas, government expenditure increases in
the supply of money through increase in the income of the people. Government
can also borrow money from commercial banks or Central bank to finance its
creditors. This may also increase in the money supply within the economy.
2. Central bank controls money supply through its monetary measures. It issues
currency and also deposits money.
3. Commercial banks (create credit on the basis of demand deposits).

Financial Intermediaries
Banks and other institutions that act as a link between those who have money to lend
and those who wants to borrow money are called as Financial Intermediaries. In other
words, it is typically an institution that facilitates the channeling of funds between
lenders and borrowers. That is, it takes deposits from savers (the lenders). From the
pool of deposited money they may lend directly to borrowers. This may be in the form of
loans or mortgages. Alternatively, they may lend the money indirectly via the financial
markets. The main types of financial intermediary are Commercial Bank, Life insurance
companies, Development Banks, pension funds etc.
Commercial Banks
A commercial bank is a type of financial institution that accepts deposits, offers
checking account services, makes various loans, and offers basic financial products
like certificates of deposit (CDs) and savings accounts to individuals and small
businesses. A commercial bank is where most people do their banking, as opposed to
an investment bank.

Commercial banks make money by providing loans and earning interest income from
those loans. The types of loans a commercial bank can issue vary and may include
mortgages, auto loans, business loans, and personal loans. A commercial bank may
specialize in just one or a few types of loans.

Customer deposits, such as checking accounts, savings accounts, money market

accounts, and CDs, provide banks with the capital to make loans. Customers who
deposit money into these accounts effectively lend money to the bank and are paid
interest. However, the interest rate paid by the bank on money they borrow is less than
the rate charged on money they lend.

Credit Creation by Commercial Banks: Credit creation separates a bank from other
financial institutions. In simple terms, credit creation is the expansion of deposits. And,
banks can expand their demand deposits as a multiple of their cash reserves because
demand deposits serve as the principal medium of exchange.
Cash or cheques are deposited in banks by the public. These deposits are known as
the actual reserves or primary deposits. Commercial banks create credit by advancing
loans and purchasing securities. They lend money to individuals and businesses out of
deposits accepted from the public out of their deposits. The liabilities of the banks are
equal to the deposits. Banks cannot use the entire amount of public deposits for lending
purposes. They have to keep some reserves out of the deposits (called Reserve Ratio)
and can lend the remaining portion of public deposits. This reserve ratio is fixed by the
Central Bank and has two components. A part of reserve ratio is to be kept with central
Bank called as Cash Reserve Ratio (CRR). Another part of reserve ratio should be kept
by the banks itself called as Statutory Liquidity Ratio (SLR). If bank has deposits of
$1000 and the reserve ratio is 20 percent. The required reserve amount is $200
($1000*20percent). According to Benham’s, “a bank may receive interest simply by
permitting customers to overdraw their accounts or by purchasing securities and paying
for them with its own cheques, thus increasing the total bank deposits.”
The difference between actual reserves and the required reserves is called as excess
reserves or loanable amount.
Excess Reserve = Actual Reserves – Required Reserve

A bank can make loan only if it has excess reserve. When bank provides loan, it creates
demand deposits. There are two ways of analyzing the credit creation process:

a. Credit creation by a single bank

b. Credit creation by the banking system as a whole
Credit creation by a single bank
In a single bank system, one bank operates all the cash deposits and cheques. The
process of creating credit is explained with the hypothetical example below:
Let’s assume that the bank requires to maintain a reserve of 20 percent.

 If a person (person A) deposits 1,000 rupees with the bank, then the bank keeps only
200 rupees in the reserve and lends the remaining 800 to another person (person B).
They open a credit account in the borrower’s name for the same.
 Similarly, the bank keeps 20 percent of Rs. 800 (i.e. Rs. 160) and advances the
remaining Rs. 640 to person C.
 Further, the bank keeps 20 percent of Rs. 640 (i.e. Rs. 128) and advances the
remaining Rs. 512 to person D.
This process continues until the initial primary deposit of Rs. 1,000 and the initial additional
reserves of Rs. 800 lead to additional or derivative deposits of Rs. 4,000 (800+640+512+
….).

Adding the initial deposits, we get total deposits of Rs. 5,000. In this case, the credit
multiplier is 5 (reciprocal of the RR) and the credit creation is five times the initial excess
reserves of Rs. 800. Hence, the initial deposit of Rs. 1,000 with bank A leads to a creation
of total deposits of Rs. 5,000.

Multiple Credit Creation by the Banking System

The banking system has many banks in it and it cannot grant loans in excess of the cash it
creates. When a bank creates a derivative deposit, it loses cash to other banks.

The loss of deposit of one bank is the gain of deposit for some other bank. This transfer of
cash within the banking system creates primary deposits and increases the possibility for
further creation of derivative deposits. Here is an illustration to explain this process better:
Suppose you deposit Rs. 1,000 in a bank A, which is the primary deposit of the bank.
The cash reserve requirement of the central bank is 20percent. In such a case, bank A
would keep Rs. 200 as reserve with the central bank and would use remaining Rs. 800
for lending purposes.
The bank lends Rs. 800 to Mr. X by opening an account in his name, known as demand
deposit account. However, this is not actually paid out to Mr. X. The bank has issued a
cheque-book to Mr. X to withdraw money. Now, Mr. X writes a check of Rs. 800 in favor
of Mr. Y to settle his earlier debts.

The cheque is now deposited by Mr. Y in bank B. Suppose the cash reserve
requirement of the central bank for bank B is 20 percent. Thus, Rs. 160 (20percent of
800) will be kept as reserve and the remaining balance, which is Rs. 640, would be
used for lending purposes by bank B.

Thus, this process of deposits and credit creation continues till the reserves with
commercial banks reduce to zero.

The process of credit creation can also be learned with the help of following formulae:
Total Credit Creation = Original Deposit * Credit Multiplier

Money Multiplier:
Money Multiplier or Deposit multiplier or credit multiplier measures the amount of money
that the Banks are able to create in the form of deposits with every unit of money it
keeps as reserves.

It is calculated as:
1
Money multiplier or credit multiplier =
r

where r = cash reserve requirement also called as Cash Reserve Ratio (CRR)

1 1
Credit multiplier = percent = = 10
10 10/100

It signifies that for every unit of money kept as reserves, banks are able to create 10
units of money.

Total credit created = 10,000 *10 = 100000

If CRR changes to 5percent,

1 1
Credit multiplier co-efficient = percent = = 20
5 5/100

Total credit creation = 10000 * 20 = 200000

Thus, it can be inferred that lower the CRR, the higher will be the credit creation,
whereas higher the CRR, lesser will be the credit creation. With the help of credit
creation process, money multiplies in an economy.
Central Bank
A central bank is an independent national authority that conducts monetary
policy, regulates banks, and provides financial services including economic research. Its
goals are to stabilize the nation's currency, keep unemployment low, and prevent
inflation.
According to Bank of International Settlement, “A Central Bank is the bank in any
country to which has been entrusted the duty of regulating the volume of currency and
credit in that country.”
Monetary policy
Central banks affect economic growth by controlling the liquidity in the financial system.
Monetary policy is concerned with the changes in the supply of money and credit. It
refers to the policy measures undertaken by the government or the central bank to
influence the availability, cost and use of money and credit with the help of monetary
techniques to achieve specific objectives. Monetary policy aims at influencing the
economic activity in the economy mainly through two major variables, i.e., (a) money or
credit supply, and (b) the rate of interest.
The central bank of a country is the traditional agent which formulates and operates
monetary policy. Needless to say that the monetary policy in India is carried out by the
Reserve Bank of India.

In the Indian context, monetary policy comprises those decisions of the government and
the Reserve Bank of India which directly influence the volume and composition of
money supply, the size and distribution of credit, the level and structure of interest rates,
and the direct and indirect effects of these monetary variables upon related factors such
as savings and investment and determination of output, income and price.

A monetary policy is regarded as passive when the central bank decides to abstain
deliberately from applying monetary measures and active when it seeks to achieve
certain ends through the enforcement of positive monetary measures.

Monetary policy is only a means to an end and not an end in itself. The aims, objects
and scope of monetary policy are conditioned both severally and collectively by the
economic environment and philosophy of time. Monetary policy has to be structured and
operated within the institutional framework of the money market of the country.

Monetary policy itself cannot be ordained to operate, on its own, as a full proof
controlling measure but rather in conjunction with the fiscal policy and debt
management. In fact, monetary policy, fiscal policy and debt management may be
lumped together to form a national financial policy. “Monetary policy is one important
segment of an overall financial policy which has to be operated in the overall milieu
prevailing in the country,” says P.D. Ojha.
Traditionally, credit control measures and decisions are the constituent elements of a
monetary policy. Monetary and credit policies operate on the following inter-related
factors:

i. Availability of credit and its flow;

ii. Volume of money;

iii. Cost of borrowing, that is, the rate of interest; and

iv. General liquidity of the economy.

There are two facts of monetary policy in a developing economy: (1) positive, and (2)
negative. In its positive aspect, it sets out the promotional role of central banking in
improving the savings ratio and expanding credit for facilitating capital formation. In its
negative approach, it implies a regulatory phase of restricting credit expansion, and its
allocation according to the absorbing capacity of the economy.

Objectives of Monetary Policy

The primary objectives of monetary policies are the management of inflation or
unemployment, and maintenance of currency exchange rates. The targets of monetary
policy refer to such variables as the supply of bank credit, interest rate and the supply of
money.

Inflation

Monetary policies can target inflation levels. The low level of inflation is considered to be
healthy for the economy. However, if the inflation is high, the monetary policy can
address this issue.

Unemployment

Monetary policies can influence the level of unemployment in the economy. For
example, an expansionary monetary policy generally decreases unemployment
because the higher money supply stimulates business activities that lead to the
expansion of the job market.

Currency exchange rates

Using its fiscal authority, a central bank can regulate the exchange rates between
domestic and foreign currencies. For example, the central bank may increase the
money supply by issuing more currency. In such a case, the domestic currency
becomes cheaper relative to its foreign counterparts.
Instruments of Monetary Policy:
The instruments of monetary policy are of two types: first, quantitative, general or
indirect; and second, qualitative, selective or direct. They affect the level of aggregate
demand through the supply of money, cost of money and availability of credit. Of the
two types of instruments, the first category includes bank rate variations, open market
operations and changing reserve requirements. They are meant to regulate the overall
level of credit in the economy through commercial banks. The selective credit controls
aim at controlling specific types of credit. They include changing margin requirements
and regulation of consumer credit. We discuss them as under:

Bank Rate Policy:

The bank rate is the minimum lending rate of the central bank at which it rediscounts
first class bills of exchange and government securities held by the commercial banks.
When the central bank finds that inflationary pressures have started emerging within the
economy, it raises the bank rate. Borrowing from the central bank becomes costly and
commercial banks borrow less from it.

The commercial banks, in turn, raise their lending rates to the business community and
borrowers borrow less from the commercial banks. There is contraction of credit and
prices are checked from rising further. On the contrary, when prices are depressed, the
central bank lowers the bank rate.

It is cheap to borrow from the central bank on the part of commercial banks. The latter
also lower their lending rates. Businessmen are encouraged to borrow more.
Investment is encouraged. Output, employment, income and demand start rising and
the downward movement of prices is checked.

Open Market Operations:

Open market operations refer to sale and purchase of securities in the money market by
the central bank. The central bank can affect the money supply by conducting open
market operations, which affects the securities rate. In open operations, the central
bank buys and sells government securities in the open market. If the central bank wants
to increase the money supply, it buys government bonds. This supplies the
securities dealers who sell the bonds with cash, increasing the overall money supply.
Conversely, if the central bank wants to decrease the money supply, it sells bonds from
its account, thus taking in cash and removing money from the economic system.

Changes in Reserve Ratios:

This weapon was suggested by Keynes in his Treatise on Money and the USA was the
first to adopt it as a monetary device. Every bank is required by law to keep a certain
percentage of its total deposits in the form of a reserve fund in its vaults and also a
certain percentage with the central bank.

The central bank can influence the money supply by modifying reserve requirements,
which generally refer to the amount of funds banks must hold against deposits in bank
accounts. By lowering the reserve requirements, banks are able to loan more money,
which increases the overall supply of money in the economy. Conversely, by raising the
banks' reserve requirements, the central bank is able to decrease the size of the money
supply.

Selective Credit Controls:

Selective credit controls are used to influence specific types of credit for particular
purposes. They usually take the form of changing margin requirements to control
speculative activities within the economy. When there is brisk speculative activity in the
economy or in particular sectors in certain commodities and prices start rising, the
central bank raises the margin requirement on them.

The result is that the borrowers are given less money in loans against specified
securities. For instance, raising the margin requirement to 60percent means that the
pledger of securities of the value of Rs 10,000 will be given 40percent of their value, i.e.
Rs 4,000 as loan. In case of recession in a particular sector, the central bank
encourages borrowing by lowering margin requirements.

Expansionary vs. Contractionary Monetary Policy

Depending on its objectives, monetary policies can be expansionary or contractionary.

Expansionary Monetary Policy

It is a monetary policy that aims to increase the money supply in the economy by
decreasing interest rates, purchasing government securities by central banks, and
lowering the reserve requirements for banks. An expansionary policy lowers
unemployment and stimulates business activities and consumer spending. The overall
goal of the expansionary monetary policy is to fuel economic growth. However, it can
also possibly lead to higher inflation.

Contractionary Monetary Policy

The goal of a contractionary monetary policy is to decrease tmoney supply in the

economy. It can be achieved by raising interest rates, selling government bonds, and
increasing the reserve requirements for banks. The contractionary policy is utilized
when the government wants to control inflation levels.

Contribution of Monetary Policy

Monetary policy can contribute to the achievement of economic growth in two ways:
1. Management of Aggregate Demand:
The monetary authority should keep the aggregate monetary demand in balance with
the aggregate supply of goods and services. For this a flexible monetary policy is called
for. A restrictive money policy will have to be applied when there is excess demand in
the economy threatening to raise prices and create conditions of unsustainable boom.
An expansionist credit policy is to be followed when there is a deficiency of aggregate
demand and supply is in excess causing a fall in prices, production, employment and
income.

It is sometimes argued that a tight or restrictive money policy impedes while an

expansionist or easy money policy promotes economic growth. But as a matter of fact,
neither view is true, since the truth lies somewhere midway. A tight money policy is not
conducive to growth when it is applied at a wrong time, say when there is a deficient
demand.

In a situation of the deficient demand and unemployed resources, an easy money policy
is most suitable, but if it is carried far beyond the stage of full employment, it will
generate an inflationary impact, and to control a speculative boom in such a situation, a
tight money policy will be appropriate.

Thus, the important thing is that they should be applied at the appropriate time;
otherwise, they do more harm than good to economic growth. Therefore, a flexible
monetary policy has been advocated to achieve economic growth with price stability.
Briefly, thus, the monetary policy can assist in promoting economic growth by
maintaining reasonable price stability and optimum use of economic resources in an
economy.

2. Encouragement to Saving and Investment:

The monetary authority can help economic development by creating a favourable
environment for saving and investment which greatly influence economic growth. For
this, the monetary policy’s aim of price stabilisation is very important. Reasonable price
stability encourages both saving and investment. As saving is the main source of capital
formation, when saving increases under favourable circumstances, capital formation
can also be accelerated which in turn accelerates economic growth.

In short, a monetary policy is necessarily concerned with all the major objectives of
economic policy, namely, exchange stability, price and economic stability, full
employment, and economic growth. These objectives are, to some extent, in conflict
with one another.

However, few people are willing to admit that any one of these objectives is undesirable
and should be abandoned. Also, there is no common denominator of stability in terms of
ends towards which a monetary policy can be directed. Thus, monetary authorities are
always confronted with the problem of priorities. They have to resolve the conflicts
between various objectives by assigning different degrees of importance to the different
objectives in different economic situations.

Summary

1. Money is the set of assets in an economy that people regularly use to buy goods
and services from others. There are three important functions of money :Medium
of Exchange, Store of Value, and Unit of Account.
 2. Money supply is the stock of money in circulation. There are various definitions of
money supply. M1 (transaction money) includes currency, demand deposits and
other deposits. M2 (board money)includes M1 + saving deposits with Post Office
Saving Banks; M3inculdes M1 + Net Time-deposits of Banks and M4 M3 + Total
deposits with Post Office Saving Organisation (excluding NSC).
3. Banks create money by making loans. When a bank makes a loan to customer, it
creates deposits in that customer’s account. This deposit becomes part of the
money supply. Banks can create credit only when they have excess reserve.
1
4. Money multiplier or credit multiplier =
r
5. A Central Bank is the bank in any country to which has been entrusted the duty
of regulating the volume of currency and credit in that country.
6. Monetary policy is concerned with the changes in the supply of money and credit.
It refers to the policy measures undertaken by the government or the central
bank to influence the availability, cost and use of money and credit with the help
of monetary techniques to achieve specific objectives. Monetary policy aims at
influencing the economic activity in the economy mainly through two major
variables, i.e., (a) money or credit supply, and (b) the rate of interest.
7. The instruments of monetary policy are of two types: first, quantitative, general or
indirect; and second, qualitative, selective or direct. They affect the level of aggregate
demand through the supply of money, cost of money and availability of credit. Of the two
types of instruments, the first category includes bank rate variations, open market
operations and changing reserve requirements. They are meant to regulate the overall
level of credit in the economy through commercial banks. The selective credit controls
aim at controlling specific types of credit. They include changing margin requirements
and regulation of consumer credit.
8. Expansionary monetary policy increases the money supply in the economy whereas
contractionary monetary policy that aims to increase the money supply in the economy

Key Words
Bank Rate: Bank Rate is the rate of interest, announced by the Central Bank, at which it
rediscounts securities of commercial banks like discounted bills of exchange, treasury
bills.
CRR (Cash Reserve Ratio): Commercial banks are required to maintain a portion of
their total deposits (demand deposits, i.e., savings bank deposits and current account
deposits, and time or fixed deposits) in cash and/or as deposit with central banks. This
is known as Cash Reserve Ratio (CRR).
According to the Banking Regulation Act, 1949, RBI can vary the CRR between 3 per
cent and 15 per cent. This is a direct instrument of monetary policy used by the RBI until
the late-1990’s. An increase (decrease) in the CRR reduces the funds available to the
banks for lending, and tightens (loosens) the liquidity conditions in the economy.
Money Supply: Aggregate money supply is argued to be the major determinant of
inflation in an economy with a stable demand for money function. The most commonly
used definitions of money supply are M1 (or narrow money), M2 and M3 (or broad
money). Narrow money, as the name suggests, is a narrow definition in the sense that it
includes two most liquid monetary assets – urrency with the public (currency notes and
coins in circulation plus cash in hand with banks) and deposit money of the public
(demand deposits with banks plus other deposits with RBI). Since demand deposits (or
checkable deposits – basically savings bank deposits and current account deposits) can
be converted into cash at any point of time, this is almost as liquid as currency with the
public. M2 includes M1 and post office savings bank deposits. M3 (or broad money) is
defined as M2 plus time deposits with banks.
Schedule Commercial Bank: A commercial bank whose name appears in the Second
Schedule of the Reserve Bank of India Act, 1934, is known as Scheduled Commercial
Bank.
SLR (Statutory Liquidity Ratio): Commercial banks are required to maintain a certain
percentage of their total demand and time liabilities in liquid assets like approved
securities (mostly securities of the Central Government and State governments and
bonds issued by the PSUs), gold and cash (apart from CRR).