3.2.2 - Supply of Money
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Introduction to Money Supply
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Today we're discussing the supply of money in our economy. Can anyone tell me what money supply consists of?
Is it just cash and coins?
Good point! It's actually both cash and bank deposits. We often categorize money into narrow and broad money. Can someone explain what narrow money might be?
I think narrow money is mostly cash and demand deposits.
Exactly! Narrow money includes currency held by the public as well as demand deposits in banks. Now, what about broad money?
Broad money would include narrow money plus savings and time deposits.
Spot on! Broad money is indeed a wider measure which includes all kinds of deposits. Let's always remember: narrow is cash and demand deposits, broad is everything plus those time deposits. That can be summarized as 'C&D for Narrow, All for Broad' - a mnemonic to remember!
Alright, let's move to how this money is created.
Role of the Central Bank
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The central bank, like the Reserve Bank of India, plays a vital role. What do you think is its primary function related to money supply?
Is it issuing currency?
Yes, that's right! The central bank issues currency which forms the high-powered money. Can anyone tell me what high-powered money is?
It's the basis for credit creation, right?
Exactly, it's sometimes called reserve money. The central bank controls the money supply through various tools. Can you name one?
The reserve ratio or CRR?
Correct! The Cash Reserve Ratio determines how much money banks must hold in reserve. Remember, 'CRR is Cash Reserve Ratio' to keep it straight! Now, let’s discuss commercial banks.
Commercial Banks and Money Creation
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Commercial banks are crucial in creating money. How do they operate?
They take deposits and give out loans, right?
Exactly! When banks lend money, they create new deposits. Let's illustrate this. If a bank has Rs 100 and the CRR is 20%, what can it lend out?
They could lend Rs 80, right?
Correct! They need to keep Rs 20 in reserve. This is how the money multiplier works. Does anyone know how we calculate it?
It would be 1 divided by the reserve ratio!
Yes! If the reserve ratio is 20%, the multiplier is 5. So for every Rs 1 of reserves, the bank can create Rs 5 of deposits! Remember, 'Multiplier Magic: 1 ÷ Reserve.'
Limits to Credit Creation
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Banks can create a lot of money, but they have limits. What determines these limits?
I think the reserve requirements set by the central bank.
Right! Additionally, the demand for loans also influences this. If banks lend too much, what could happen?
It could lead to liquidity issues?
Exactly! Hence, maintaining a balance is crucial. Remember, 'Lending needs Limits!'. Let’s summarize what we've learned today.
Introduction & Overview
Read summaries of the section's main ideas at different levels of detail.
Quick Overview
Standard
The supply of money in an economy is primarily managed through the actions of the central bank and commercial banks. It explores how both institutions contribute to the availability of money through currency issuance and deposit creation, while also explaining key concepts such as high-powered money and reserve ratios.
Detailed
In a modern economy, the supply of money is comprised mainly of cash and bank deposits, regulated by two main institutions: the central bank and commercial banks. The central bank, such as the Reserve Bank of India (RBI), issues currency and manages the money supply using tools like bank rates and reserve ratios. Commercial banks contribute to money creation by accepting deposits and issuing loans, thereby expanding the money supply. The concept of high-powered money, which serves as the basis for credit creation, is emphasized. Furthermore, the section delves into the mechanics of money supply, including the definitions of narrow and broad money, the processes involved in banking transactions, and ultimately the limits to credit creation determined by reserve requirements. The significance of these processes lies in their effect on economic stability and growth.
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Introduction to Money Supply
Chapter 1 of 6
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Chapter Content
In a modern economy, money comprises cash and bank deposits.
Depending on what types of bank deposits are being included, there are many measures of money. These are created by a system comprising two types of institutions: central bank of the economy and the commercial banking system.
Detailed Explanation
Money in a modern economy isn't just physical cash but also includes bank deposits. The definition of money can vary depending on which types of deposits are included. Essentially, money supply refers to the total amount of liquid cash and cash equivalents available in an economy and it is regulated by institutions like the central bank and commercial banks.
Examples & Analogies
Think of money supply like the water in a reservoir. Just as the water level can rise or fall based on inflow and outflow, the money supply can change based on how much cash is created and how much is withdrawn from circulation.
Role of the Central Bank
Chapter 2 of 6
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Central Bank is a very important institution in a modern economy. Almost every country has one central bank. India got its central bank in 1935. Its name is the ‘Reserve Bank of India’. Central bank has several important functions.
Detailed Explanation
The central bank, like the Reserve Bank of India, plays a critical role in managing a nation's economy. It is responsible for issuing currency, controlling the money supply, and acting as a banker to the government. It uses various methods to regulate how much money is in circulation, impacting overall economic activity.
Examples & Analogies
Consider the central bank as the conductor of an orchestra; just as a conductor ensures all musicians are playing together in harmony, the central bank works to maintain the stability of the economy by managing money supply and maintaining a balance.
Commercial Banks and Money Creation
Chapter 3 of 6
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Chapter Content
Commercial banks are the other type of institutions which are a part of the money-creating system of the economy. In the following section we look at the commercial banking system in detail. They accept deposits from the public and lend out part of these funds to those who want to borrow.
Detailed Explanation
Commercial banks accept deposits (money) from the public and use a portion of these deposits to lend to borrowers. This process creates new money through the loans given, as borrowers can spend this money, effectively bringing it back into circulation, thereby increasing the total money supply.
Examples & Analogies
Imagine a baking factory where flour is the money. When flour is deposited (deposited in a bank), some is used to bake bread (loans), which is then consumed. This cycle shows how deposits turn into new money through lending.
The Story of Lala the Goldsmith
Chapter 4 of 6
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Chapter Content
In order to understand this process, let us discuss a story. Once there was a goldsmith named Lala in a village. In this village, people used gold and other precious metals in order to buy goods and services. People in the village started keeping their gold with Lala for safe-keeping.
Detailed Explanation
The story illustrates how banking operates. Lala, acting as a goldsmith, accepted gold deposits and issued receipts (representing 'money'). These receipts gradually became accepted as money for transactions. This scenario simplifies the concept of how banks create money by issuing more receipts than the actual gold, reflecting real-world lending practices.
Examples & Analogies
This model can be related to how modern banks operate today. When you deposit money, the bank does not keep all of it in the vault but lends a portion out, thus increasing the effective money supply available for everyone.
Risks of Lending
Chapter 5 of 6
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Chapter Content
However, Lala could decide that everyone with gold deposits will not come to withdraw their deposits at the same time and so he may as well give the loan to Ramu and charge him for it.
Detailed Explanation
Lending money involves a risk as banks must ensure that they have enough liquidity—the capability to meet withdrawal demands. Lala believes not everyone will demand their deposits at once, allowing him to extend a loan without losing deposits. This principle is foundational in banking where banks operate on a fractional reserve basis.
Examples & Analogies
Think of a restaurant that seats 100 people, but the chef prepares only enough food to serve 80. If the restaurant is careful and only 40 guests show up, the chef can manage. However, if suddenly 100 people arrive, the restaurant cannot fulfill all orders, representing the liquidity risks banks face.
Money Creation Dynamics
Chapter 6 of 6
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Chapter Content
The modern banking system works precisely the way Lala behaves in this example. Commercial banks mediate between individuals or firms with excess funds and lend to those who need funds. People with excess funds can keep their funds in the form of deposits in banks and those who need funds, borrow funds.
Detailed Explanation
The banking system creates money through the lending process. When banks lend, they essentially create new money because they are not physically handing out the deposits in cash but rather ensuring that these funds are used in transactions, thus expanding the money supply.
Examples & Analogies
It's like a library system where books (money) can circulate. When one person checks out a book, they can read it, share insights, and discuss with others, thereby multiplying the influence of that one book. Similarly, the way banks lend out money boosts economic activity.
Key Concepts
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Supply of Money: The total amount of money available in an economy at a particular time, regulated by the central bank and commercial banks.
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High-Powered Money: The base currency that includes the reserves held by banks and is issued by the central bank.
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Central Bank Functions: The central bank manages monetary policy, acts as a lender of last resort, and regulates the money supply.
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Commercial Banks' Role: Banks create money by accepting deposits and providing loans, increasing the money supply through the lending process.
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Credit Creation Limits: The central bank sets reserve requirements that limit the amount of money banks can create through loans.
Examples & Applications
In a modern economy, the central bank sets a reserve ratio, ensuring banks must keep a specific percentage of deposits as reserves. For instance, if the reserve ratio is set at 20%, banks can lend out 80% of the deposits they receive.
If a commercial bank receives a deposit of Rs 100 and the Cash Reserve Ratio is 10%, it must keep Rs 10 in reserve and can lend Rs 90. This process continues as new deposits are created, showcasing the money multiplier effect.
Memory Aids
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Rhymes
To keep money in flow, lend some and grow, the bank's got the key, to multiply money!
Stories
Imagine a town where one bank has Rs 100. They can lend Rs 80, helping people invest and spend, which creates a ripple effect of new deposits from borrowed funds, soaking up the economy's needs.
Memory Tools
The acronym 'CRR' - 'Cash Reserve Rules' helps us remember that it governs how much banks must keep in reserve.
Acronyms
M^3 stands for Money, Multiplier, and Management of monetary supply.
Flash Cards
Glossary
- Central Bank
A primary financial institution that issues currency, controls money supply, and oversees the banking system.
- Commercial Banks
Banks that accept deposits and make loans, contributing significantly to money creation through the banking system.
- HighPowered Money
The portion of the money supply that acts as a reserve and is created by the central bank.
- Cash Reserve Ratio (CRR)
The percentage of total deposits that banks must hold as reserves with the central bank.
- Money Multiplier
The factor by which a change in reserves will change the money supply, calculated as 1 divided by the reserve ratio.
- Narrow Money
A measure of the money supply that includes all physical currency and demand deposits.
- Broad Money
A measure of the money supply that includes narrow money and other types of deposits, such as savings accounts.
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