Monetary Policy DD 5

7/21/2019 Monetary Policy DD 5

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Monetary Policy

Regulating money supply in the economy

in order to promote growth and ensure

price stability is monetary policy.Monetary policy is the responsibility of

Central Bank (RBI in India).


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Central and Commercial Bank

Commercial Bank accepts deposit and

lends a part of it to make profit.

Central Bank controls commercial banks,

issues currency notes, controls credit and

money supply, acts as banker to the

government and manages foreign

exchange position of the country.


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Control of money supply

Without adequate money supply, an

economy cannot function

But too much money causes price

instability and inflation.

So fine tuning money supply is an

important task.

Central Bank is to do this regulating act.


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What is money

Money is the abode of purchasing power

Its main characteristic is universal

acceptability as a medium of exchange.

Currency has this feature.

Cheques drawn on demand deposits of

commercial banks also have this feature. So money is currency + demand deposit.


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Creation of money supply

When part of demand deposit is lent, more

purchasing power is created.

Demand depositor can buy with cheque

and agent who borrows part of demand

deposit can also buy.

So lending actually creates money i.e.

purchasing power.

This is called credit creation.


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Credit control

As more credit means more money,

Central Bank may have to reduce credit

during inflation.

Similarly during recession central bank

has to increase credit.

Central Bank does this by controlling the

lendable fund in the hands of commercial

banks.


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Credit creation

We know that banks have to maintain a reserveratio, fixed by central bank. This leads to a

multiplied credit creation.

Suppose A bank gets INR 1000 from centralbank through open market purchase.

Assume reserve ratio is 10%. Then A Bank

lends 900.

This money is deposited to bank B, which lends

INR 810.

Now purchasing power in the economy is 900 +810 = 1710


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Credit Creation

This process now goes on, as follows.

1000+900+810+729..

Purchasing power increases because the

initial depositor holds his purchasingpower but who gets the loan out of this

deposit also can buy with the loan.

If the above series goes on indefinitely weget

Initial deposit (1000)X (1/CR)=INR 10000


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Money Supply Function

M = C + D M = Money, C = Currency and D =

Demand Deposit.

R = bD R = Reserve, b = R/ D = Reserve Ratio.

C = kD, k = Currency deposit ratio.

M = kD + D = (1+k)D R + C = bD +kD = (b +k)D

M =[(1+k)/(b+k)](R+C) = mH


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Money Supply Function

M =[(1+k)/(b+k)](R+C) = mH

H = High power money or monetary base

M = Money multiplier. Money multiplier falls if k or b rises.

That is, money multiplier falls if people

hold more currency or commercial banksmaintain more reserves.


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Need for control of money

supply The above result shows that a money

multiplier operates in the economy.

So if price rises at a high rate on account

of excess money supply, central bank will

curtail the loan giving power of the

commercial banks.

This will adversely affect the banks

profitability.

Documents

Monetary Policy DD 5