UNIT 4 FUNCTIONS OF MONEY

Structure
4.0 Objectives
4.1 Introduction
4.2 Functions of Money
4.3 Measures of Money Supply
4.4 Hot Money
4.5 Credit Creation by Banking System *
4.6 Let Us Sum Up
4.7 Answers/ Hints to Check Your Progress Exercises

4.0 OBJECTIVES
After going through this unit, you would be in a position to
 explain the concept and functions of money;
 illustrate the measures of money supply in India;
 explain the concept of hot money; and
 demonstrate how banks create credit under the fractional reserve banking
system.

4.1 INTRODUCTION
Ordinarily, money is spoken about in terms of income or wealth. For instance, a
person may say that he has a lot of money (that is, wealth) or he made of lot of
money in the previous year (that is, income). But, economists use the term
‘money’ in a more technical sense. In economics, money is the stock of assets
which is used to pay for things or for transaction purposes. It is a medium of
exchange; for example, cash in the hands of public (any currency – rupee, dollar,
yen, etc.).

What led to the evolution of money or paper money? Going back to the ‘barter
system’, such a trade is simply inconvenient and it also requires a double
coincidence of wants which is not always possible. Hence, a better and easier
method of facilitating transactions had to evolve. The evolution of commodity
money is not surprising as people readily accept commodities having some
intrinsic value. In the past, commodities such as gold were used as money. Such
type of money having an intrinsic value (for example, gold can be used as
jewelry) is called ‘commodity money’. During the late nineteenth century gold
standard was commonly prevalent across the world.

Under the gold standard, gold or paper money redeemable for gold was used as a
medium of exchange. But what led to the development of fiat money? It is

*
Ms. Priti Aggarwal, Assistant Professor, College of Vocational Studies, University of Delhi
Money in a Modern surprising as people value an intrinsically useless commodity such as paper. The
Economy inconvenience of carrying around bags of gold and weighing it every time a
transaction is conducted led to the development of ‘fiat money’. Gold has to be
checked for purity and weight whenever an exchange is made. Alternatively, the
government can issue gold coins of known purity and weight to be used for
transactions. As a next step, these gold coins are replaced by gold certificates, or
paper bills which the public can redeem for gold. Even such a gold backing
becomes irrelevant in the end as everyone values paper money and does not care
to redeem it for gold. Hence, fiat money evolved because of social convenience
of using it. Paper money or fiat money has no intrinsic value but government
decree or fiat establishes paper currency as money.
In this unit we will discuss the functions of money and measurement of money
supply. Also, we will learn about the hot money, and its effect on the domestic
economy. Then we will learn about the money multiplier. The monetary base
increases manifold over time, which increases the money stock in a
multiplicative manner in the economy.

4.2 FUNCTIONS OF MONEY

Broadly, the functions of money are as follows:
Store of Value
Money is a store of value as it can be saved and spent in the future. In other
words, it can be used to carry forward the purchasing power into the future.
However, it is not a perfect store of value. If the prices are rising, the purchasing
power of money declines.
Unit of Account
Money is similar to a yardstick or a measuring rod. Prices of all commodities are
quoted in monetary terms. Even though resource allocation is based on relative
prices, that is, price of one commodity versus another, prices are not quoted in
relative terms. We do not see price of a computer expressed in terms of prices of
onions, for instance. Hence, money plays a very important role of measuring
economic transactions.
Medium of Exchange
As pointed out earlier, money is the medium which facilitates exchange of goods
and services in an economy. It is the economy’s most liquid asset as it can be
easily used for buying goods and services. An asset is said to be liquid if it can be
used immediately, conveniently and cheaply for making payments.
Standard of Deferred Payment
Money is also a standard of deferred payment as the amount to be repaid in the
case of loans are specified in monetary terms. But due to erosion in the
purchasing power of money due to increasing price level, sometimes, the loan is
indexed such that the amount to be repaid is related to the expected price level or
the rate of inflation.

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 Function of Money
4.3 MEASURES OF MONEY SUPPLY

How is the quantity of money or the money supply in the economy measured? As
per the definition of money, the quantity of money is the stock of assets used for
transactions in the economy. Such a stock can be measured easily in simple
economies with commodity money in prevalence. In this case, the quantity of
money is the number of units of the commodity used as money. In complex
economies, various assets such as cash, checking account deposits, etc. are used
for transactions. Therefore, various assets can be included in money supply.
Currency is included and so are demand deposits (e.g., deposits in the current
account). Cheques or debit cards against current account or saving account can be
used as conveniently as money. Since many assets qualify for inclusion in the
money stock, there are various measures of money supply depending on which
assets are included.
There are four measures of money supply in India: M1, M2, M3 and M4. We
start with the most liquid measure of money supply, M1. It includes the liquid
claims which can be used directly, instantly and without restrictions to make
payments. Hence, it is closer to the definition of money as a means of payment.
The liquidity decreases as we move to other monetary aggregates, viz., M2, M3
and M4 in that order. Hence, M4 is the least liquid measure of money supply. We
define each of the above-mentioned measures below.

M1= CU + DD + OD = Currency held by the public (Coins and notes in

circulation) + Demand Deposits in Banks + Other Deposits in RBI

Demand deposits are those deposits which the account holders can withdraw any
time (e.g., current account deposits). Saving deposits are not included in demand
deposits because they are subject to withdrawal restrictions. Other deposits with
the RBI include demand deposits of public financial institutions, demand deposits
of foreign central banks and financial institutions like IMF, World Bank, etc.

M2 = M1 + Saving Deposits of Post Office Saving Banks

M3 = M1 + Net Time Deposits of Banks
M4 = M3 + Total Deposits of Post Office Savings Organization (excluding
National Saving Certificates or NSC)

Here, M1 is also known as ‘narrow money’. Saving deposits of post offices do

not serve the medium of exchange function of money as they do not have cheque
facility. Hence, they are not included in M1. Similarly, fixed deposits are not
included in M1. You should note that M3 is known as ‘broad money’ since it
includes time deposits as well. For macroeconomic policy formulations, the RBI
takes into account M3 measure of money supply. Interest bearing bank account
deposits which cannot be withdrawn prior to the maturity date are known as ‘time
deposits’. Banks receive more money as time deposits compared to demand deposits.

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Money in a Modern In addition to the above, there is another measure of money supply, that is, M0.
Economy The M0 is also known by several other names such as ‘monetary base’, ‘central
bank money’, ‘high-powered money’ and ‘reserve money’.

Reserve Money = Currency in Circulation + Bankers’ Deposits with the RBI

(M0) + Other Deposits with the RBI

= Net RBI credit to the government + RBI credit to the

commercial sector + RBI’s claims on banks + RBI’s net
foreign assets + Government’s currency liabilities to the
public – RBI’s net non- monetary liabilities

You should note that M0 includes all currency in circulation, whether by the
public or by the banking system. On the other hand, M1 includes currency held
by the public. The amount of money held by the banking system is much larger
than the money held by the public. Thus M0 is considerably larger than M1.

Check Your Progress 1

1. What led to the invention of paper money?

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2. What are the functions of money?

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3. What are the measures of money supply in India?

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4. Are debit cards counted in measurement of money? What about credit cards?
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 Function of Money
4.4 HOT MONEY
The term hot money is used to describe money which quickly moves from one
country to another in search of speculative gains. There is inflow of funds or hot
money in an economy if the interest rates in the economy are higher than the Rest
of the World. But such movements of funds are very volatile and they quickly
leave the economy if better returns are discovered in other countries.
You should note that Foreign Direct Investment (FDI) is not hot money, as it is
meant for long term investment. Traditionally, short term bank deposits were
used by investors to park hot money in other economies. In these days, with
financial globalization, Foreign Portfolio Investment or Foreign Institutional
Investment (FII) could be an example of hot money.

Hot money usually originates in capital-rich countries having low interest rates;
and destinations are economies with high interest rates or yield. Emerging
economies such as India, Brazil, China, Malaysia, etc. are recipients of hot
money inflows. These economies have high rates of return on investment because
of which they attract hot money inflows. India is considered a ‘safe heaven’ and
continues to be recipient of foreign capital inflows.

Although hot money positively affects consumption in the recipient country,

inflow of hot money has some negative repercussions as well, since these are
basically short-run sudden inflows of capital. It may exercise inflationary
pressures in these economies. Hot money affects the exchange rate of the
economy. Inflow of hot money appreciates the exchange rate or increases the
value of the currency. On the other hand, outflow of funds depreciates the
exchange rate. Hot money flows are very volatile subjecting the recipient
countries to instability. These flows lead to volatile stock markets and large
fluctuations in exchange rates.

Quick withdrawal of hot money from banks may also trigger a banking crisis.
Many believe that one of the causes of the 1997 East Asian Financial crisis was
sudden outflow of hot money. South Korea, Thailand and Indonesia were most
affected by this crisis. Having accumulated large amounts of short term foreign
debt which is a type of hot money, the exchange rate and asset prices in these
economies collapsed when capital started flowing out due to various factors.

4.5 CREDIT CREATION BY BANKING SYSTEM

This section discusses an important role of the banking system that is the creation
of credit. An understanding of this role of banks can be made by taking a look at
the balance sheet of a bank (see Table 4.1 below).

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Money in a Modern Table 4.1 Balance Sheet of a Bank
Economy
Assets Liabilities
Reserves Checkable Deposits
Loans

People deposit funds in the checking accounts with banks. Such funds can be
withdrawn anytime with the help of checks. Hence, the value of checkable
deposits is written on the liabilities side of the banks’ balance sheet. On the assets
side, we have loans and reserves. Some funds are held by banks as reserves,
partially as cash and partially with the central bank. These reserves are held for
several reasons. Taking any day, some people may deposits cash in their accounts
whereas others may withdraw cash. This outflow and inflow may not be equal,
making it important for banks to keep some cash on hand. Reserves are also held
for inter-bank clearing purposes.

In addition, banks are required to hold a certain fraction of their demand and time
liabilities in the form of cash balances with the central bank. Such a system is
known as the fractional reserve banking system. That is, only a fraction of the
bank deposits are backed by actual cash on hand and are available for
withdrawal. The fractional reserve banking system is the underlying basis for
creation of credit or expansion of money supply in the economy. Since all
depositors do not rush to withdraw their money at once and outflow of funds is
supported or filled by inflow of funds, banks need to keep only a fraction of
deposits as cash and they can loan out the rest. It makes credit expansion
possible.

The overall money supply in the economy is the outcome of the behaviour of
banks, public and the central bank. As already discussed in the preceding section,
the overall money supply in the economy is the sum of currency plus demand
deposits. That it,

𝑀 = 𝐶𝑈 + 𝐷𝐷 …[4.1]
Let us assume that the currency-deposit ratio is ‘c’ such that,
𝑐 = 𝐶𝑈/𝐷𝐷
Hence, overall money supply is given by,
𝑀 = (1 + 𝑐)𝐷𝐷 …[4.2]

The central bank controls the overall money supply by controlling the Monetray
Base or High Powered Money ‘H’. The high powered money consists of currency
plus reserves ‘R’. That is,

𝐻 = 𝐶𝑈 + 𝑅 … [4.3]
Let us assume that the reserve-deposit ratio is ‘r’ such that,
𝑟 = 𝑅/𝐷𝐷
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Hence, high powered money is given by, Function of Money

𝐻 = (𝑐 + 𝑟)𝐷𝐷 … [4.4]

The highpowered money and the overall money supply are linked by the money
multiplier. The money multiplier is the ratio of the stock of money to the stock
of high powered money.

( )
That is, 𝑀 = 𝐻 ≡ 𝑚𝑚 𝐻
( )

Here, "𝑚𝑚" is the money multiplier which is given by,

(1 + 𝑐)
𝑚𝑚 =
(𝑐 + 𝑟)

Hence, the money multiplier is determined by the behaviour of the public and the
banks. There are two behaviuoural ratios which determine the money multiplier:
c and r. Smaller the ‘r’, the larger the money multiplier. Smaller the ‘c’, larger the
money multiplier. This implies that if less money is held as currency or as
reserves, more is available with banks for expanding credit. The money
multiplier is larger than 1. Both ‘c’ and ‘r’ lie between 0 and 1. If c = 0, people
hold no currency. If c = 1, people hold only currency and banks have no role to
play. The currency deposit ratio depends on the costs of holding cash. If cash is
easily available through ATMs, less currency is held by public on average. The
reserve-deposit ratio includes both the required reserves and excess reserves.
Required reserves are those which banks are required to hold statutorily with the
central bank. Reserves in excess of required reserves are known as excess
reserves which banks can hold as cash on hand with themselves or as balances
with the central bank. These excess reserves are used to meet currency and
clearing drains as already discussed before.
An increase in H leads to a more than proportionate increase in overall money
supply. A given increase in H results in multiple expansion of credit, deposits and
money. For this reason, H is called High-powered money or monetary base. It is
through the operation of the money multiplier effect that banks create credit in
the economy. An example will illustrate the money multiplier process. Suppose
that the public comes to possess ∆𝐻= 60 millions. This can occur if the central
bank buys bonds from the public through open market operations. Assume that c
= 0.5 and r = 0.1. Now, people keep 20 million as currency and deposit the rest
40 million in the banks. The banks keep 4 million as reserves (r = 0.1) and lend
out 36 million.

This forms the first round of credit creation as banks lend out 36 million.
The public again holds only 12 million as currency and deposit the rest 24
million in banks since the currency-deposit ratio is 0.5. Now banks again keep 10
per cent as reserves, that is, 2.4 million. And the rest 21.6 million is loaned out.
This forms the second round of credit creation. Again, the public 7.2 million in
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Money in a Modern cash and 14.4 million as deposits with banks and the process goes on.
Economy In this manner, there are successive rounds of creation of deposit, credit and
money. With each round, the size of deposit, credit and money becomes smaller
and smaller. Each series of expansion of credit, deposit and money is an infinite
series which can be summed up. The rounds of expansion of deposits are 40, 24,
14.4….and the rounds of expansion of bank credit are 36, 21.6, 12.96…and so
on. The expansion of money supply is given by,

( )
∆𝑀 = ∆𝐻 = 2.5 ∗ 60 = 150 million
( )

Hence, an injection of 60 million of H leads to money supply expansion by 150

million.

Check Your Progress 2

1. X is an economy with no financial innovation. In this country, the Central
Bank requires the commercial banks to keep 100 per cent of their deposits as
reserves. Calculate the money multiplier for this economy.

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2. “The overall money supply in the economy is the outcome of the behaviour
of banks, public and the central bank”. Prove this statement by deriving the
money multiplier.
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4.6 LET US SUM UP

In this unit we learnt that money is the stock of assets which is used for
transaction purposes. It serves three broad functions: medium of exchange, store
of value and unit of account. The money supply is made up of currency and
demand deposits. Broader measures of money supply also include saving
deposits and time deposits as well as some interest earning assets. The overall
money supply in the economy is a multiple of the monetary base or the high
powered money. It is the fractional reserve banking system which forms the basis
of credit creation by the banks.

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 Function of Money
4.7 ANSWERS/HINTS TO CHECK YOUR PROGRESS
EXERCISES
Check Your Progress 1
1. See Section 4.1
2. See Sections 4.1 and 4.2
3. See Section 4.3
4. Credit cards are not counted in the economy’s money stock because they are a
means of deferring payment rather than making payments. When the credit card
holder clears all his dues, his checking account is used to write a cheque.

This checking account balance is a part of the economy’s money stock. Debit
cards however are used to make payments. It allows the user instant access to his
bank account. Such account balances behind debit cards are a part of the stock of
money.
Check Your Progress 2
1. Money multiplier is equal to 1.
2. See Section 4.5.

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UNIT 5 DEMAND FOR MONEY

Structure
5.0 Objectives
5.1 Introduction
5.2 Quantity Theory of Money: Fisher’s Approach
5.3 Quantity Theory of Money: Cambridge Approach
5.4 Keynesian Theory of Demand for Money
5.4.1. Transaction Demand
5.4.2. Precautionary Demand
5.4.3. Speculative Demand
5.5 Determination of Equilibrium Interest Rate
5.6 Let Us Sum Up
5.7 Answers/Hints to Check Your Progress Exercises

5.0 OBJECTIVES
After going through this unit, you would be in a position to

 explain the relationship between money supply and prices;

 distinguish between Fisher’s approach and Cambridge approach to
Quantity Theory of Money (QTM);
 explain the Keynesian theory of Demand for Money; and
 illustrate how money market equilibrium is determined.

*
5.1 INTRODUCTION

In this unit we will discuss the relationship between money supply and general
prices, which is mainly dealt by the two approaches of the Quantity Theory of
Money, viz., Fisher’s approach and Cambridge approach. Both the approaches
suggest that an increase in money supply results in proportionate increase in the
price level. In the end of this unit we will discuss the demand for money and
money market equilibrium. People hold money because it has purchasing power;
its ability to buy goods and services. We notice that a person usually holds
certain amount of money capable of buying certain goods and services. This
amount varies across persons depending upon his income, preferences, interest
rate, etc. Hence, the demand for money is the demand for real balances or (M/P).
When there is an increase in the general price level (P), nominal money balances
(M) has to be increased in proportion to the rise in the price level ceteris paribus,
to keep real balances constant.

*
Ms. Priti Aggarwal, Assistant Professor, College of Vocational Studies, University of Delhi
 Demand for Money
5.2 QUANTITY THEORY OF MONEY: FISHER’S
APPROACH

The Quantity Theory of Money is a classical theory which states that the price
level is proportional to the quantity of money in the economy. Classical
economists including Fisher emphasized the function of money as a medium of
exchange. People hold money to carry on the transactions, that is, to buy goods
and services. The value of such transactions is equal to PT, where P is the price
of a typical transaction and T is the volume of transaction of goods and services.
The value of ‘PT’ must be identical to the value of money flow used to buy
goods and services. The value of money flow is equal to the nominal quantity of
money supply ‘M’ (fixed by the central bank) multiplied by V, where V is the
transaction velocity of money or the number of times the money stock turns over
per year in order to finance the flow of transactions. That means it is the rate of
circulation of money or the number of times the currency notes change hands in a
given time period. Hence, the Fisher equation of exchange can be written as,

MV = P … (5.1)

Let us take an example. Suppose that 60 units of good Z is sold at the rate of Rs.
5 per unit in a given year. Then the value of transactions ‘PT’ is equal to Rs. 300
per year. If money supply (M) equals Rs.100, then the velocity V comes out to be
3 times per year. That is, in order for 300 rupees of transactions to take place per
year with 100 rupees of money, each rupee must change hands thrice a year. The
quantity equation is an identity, that is, the equality is maintained. If M increases
and V is constant, then either the price (P) or transactions (T) must increase.

Since the volume of transactions is difficult to measure, economists also use a

different version of Quantity Theory by replacing T with Y, the real total output
or income. In this format, the quantity equation can be written as,

MV = PY … (5.2).

The income velocity of money is the number of times the money stock turns over
per year in order to finance the annual income flow. Fisher argued that V depends
on the payment technology and the payment habits of people in society.
According to Fisher and other quantity theorists, “the equilibrium level of
velocity was determined by such institutional factors and could be regarded as
fixed in the short run”. The Classical economists also assumed that output Y is
fixed. If V and Y are assumed to be constant, the quantity equation is written as,

𝑀𝑉 = 𝑃𝑌 … (5.3).

Hence, there exists a proportional relationship between exogenous money supply

and price level. The Quantity Theory of Money suggests that change in money
supply causes a proportionate change in the price level. This is the basic result of
the Quantity Theory of money which can be summarized as: “the quantity of
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Money in a Modern money determines the price level”. This result can also be shown by expressing
Economy the quantity equation in percentage terms as shown below.

% change in 𝑀 + % change in 𝑉 = % change in 𝑃 + % change in Y … (5.4)

Here, the central bank controls the percentage change in money supply.
Percentage change in velocity is zero as velocity is assumed to be constant.
Percentage change in price level is the inflation rate. Percentage change in output
depends on growth in factors of production and technological progress which are
assumed to be given. Hence, money supply growth determines the inflation rate
(as % change in 𝑌 is assumed to be zero).

Check Your Progress 1

1. How does ATM facility affect the velocity of money?
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2. If V increases, what happens to the money demand curve?

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5.3 QUANTITY THEORY OF MONEY:

CAMBRIDGE APPROACH

A variant of the Quantity Theory of Money is the Cambridge Approach named

after Cambridge economists, Marshall and Pigou. They showed that there is a
proportionate relationship between the quantity of money and the aggregate price
level. Marshall’s focus was on the optimal amount of money that an individual
holds. People hold money to meet transaction needs and also for precautionary
motives. But holding money has an opportunity cost of lost income if the money
were to be invested in assets such as bonds which earn interest. So “money will
be held in so far as the yield in terms of convenience and security outweighs the

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income lost from not investing in productive activity”. What is the optimal Demand for Money
amount of money held by the public? These Cambridge economists assumed that
the demand for real money balances is proportional to income. That is,

= 𝑘𝑌 … (5.5)

Here, 𝑘 is the fraction of income that people wish to hold as cash balances. It is
assumed to be constant. Now, at equilibrium, money demand is equal to money
supply.

That is,

= … (5.6)

By equating (5.5) and (5.6), we find that = 𝑘𝑌

Or, M = 𝑃𝑌 … (5.7)

You should note that equation (5.7) is equivalent to 𝑀𝑉 = 𝑃𝑌, where 𝑉 = .

Thus, we see that the Fisher’s equation and the Cambridge version are
equivalent. Here, 𝑘 is the money demand parameter and 𝑉 is the velocity of
money. If people hold more money for each unit of income, V is small.
Alternatively, if people hold less money for each unit of income V is large, as
money changes hands very frequently. We observe that 𝑘 and 𝑉 are the two sides
of the same coin. Like the Fisher’s Approach where 𝑉 is assumed to be fixed, 𝑘
is also assumed to be stable in the short run.

The above discussion draws parallels between the Fisher’s approach and the
Cambridge approach to the Quantity Theory of Money. Both the approaches
arrive at the same conclusion. However, in the Cambridge approach, the Quantity
Theory is seen from the perspective of demand for money. This approach derives
the proportionate relationship between quantity of money and price level by
assuming 𝑘 and 𝑌 to be constant.

The Fisher’s approach, on the other hand, emphasizes on the supply of money. It
takes us through the channels by which money affects the price level. Let us
assume that the quantity of money doubles. It results in excess of money supply
over demand for money. People try to get rid of excess cash balances or reduce
their money holdings to optimal proportion of their income. The excess money is
put into consumption and investment increasing the demand for commodities.
This causes increase in prices. If output 𝑌 is constant and 𝑘 is constant, the price
level also doubles until the new equilibrium is attained. At this point, nominal
income (PY) as well as money demand doubles.
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Money in a Modern
Economy Check Your Progress 2
1. Discuss the Quantity Theory of Money. Are the two approaches – Cambridge
and Fischer’s – essentially the same? What are the differences?

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2. Derive the quantity equation using the money demand function.

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5.4 KEYNESIAN THEORY OF DEMAND FOR

MONEY

According to Keynes, demand for money is the preference for liquidity or the
public’s desire to hold cash and other forms of ready money like non-interest
earning deposits. Depending on his ‘liquidity preference’, an individual decides
how much of his resources or income should be held in the form of liquid money
and how much in the form of other assets. But what drives liquidity preference in
any individual given that bonds or assets yield returns whereas liquid money does
not? According to the Keynesian view, there are three reasons which create
demand for money or preference for liquidity. They are transaction demand for
money, precautionary demand for money and speculative demand for money.

5.4.1. Transaction Demand

It is unlikely that an individual receives money at the same instant he needs to
make a payment. Usually, one receives money at the end of the month but the
expenses are scattered over the month. Lack of such coordination between
receipts and expenditure gives rise to the transaction demand for money. The
transaction demand for money varies directly with income. A person with low
income will incur low expenses and thus have low transaction demand. On the
other hand, a person with high income has high transaction demand as she spends
more on transactions. Such a demand for money also depends on the trade-off
between holding cash balances and holding assets such as bonds which are
interest earning. Holding real money balances has an opportunity cost, that is, the
interest foregone. If the interest rates are high, the opportunity cost of holding
money is high. Hence, the transaction demand for money is low.
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Thus, the transaction demand for money falls with rise in the rate of interest. Demand for Money
Since, money is held in the form of currency or chequable deposits for
transaction purposes, the transaction demand corresponds with the M1 measure
of money supply (see Unit 4). It also corresponds with the medium of exchange
function of money.

5.4.2. Precautionary Demand

People also hold money to guard against uncertainties. Future receipts and
payments are uncertain. Hence, money is held to act as a buffer stock to meet
unforeseen expenses that may arise in future. For example, families may hoard
cash to meet a medical emergency which may arise without warning.
The precautionary demand for money is relevant to M1 although it can explain
savings accounts which are part of M2.

5.4.3. Speculative Demand

The speculative demand for money relates to the function of money as a store of
value. In a portfolio of assets, an investor prefers to keep those assets which yield
high returns. But returns are subject to uncertainties and assets are risky. In such
a scenario, it is wise for the investor to have a diversified portfolio wherein some
money is also held to safeguard against capital losses as prices of some assets
behave in an uncertain manner. Even money is not a completely risk-free or safe
asset. The real value of money depends on the inflation rate which is uncertain.
But the values of equities are more uncertain than the inflation rates which
explains why money is a relatively safer asset. This attribute of money creates
speculative demand for money. Essentially, it is the risk-averse behavior of
individuals which generates speculative demand for money. Higher the riskiness
of the returns on other assets, higher is the speculative demand for money. And
higher the expected return on other assets, lower is the speculative demand for
money. In a flight towards safe assets, which assets are held? Is it the currency
and demand deposits? Or time deposits and saving deposits. Investors prefer time
and saving deposits as they have higher returns. These are part of M2 and M3.
Hence, the speculative demand for money corresponds with M2 and M3 measure
of money supply.

Fig. 5.1: The LP Curve

71
Money in a Modern We learn from the above discussion that speculative demand for money is
Economy inversely related to the current rate of interest. If the current rate of interest is
low, the speculative demand for money is high as the opportunity cost of holding
money is low. Fig. 5.1 shows the speculative demand for money as a declining
function of the interest rate. The ‘liquidity preference’ curve or LP curve is
downward sloping implying that demand for liquidity or speculative demand for
money is low at high rates of interest (and vice versa). However, if the rate of
interest is very low (at 𝑟"), people are willing to hold whatever amount of money
is supplied to them. Such a region is called the Liquidity Trap region, which can
be shown as the E”LP in the Fig. 5.1. The LP curve is perfectly elastic at
𝑟" indicating ‘absolute liquidity preference’ (see the horizontal portion of the LP
curve). In the liquidity trap region, monetary policy is completely ineffective as
any increase in money supply results in no change in interest rates or investment.

Check Your Progress 3

1. What is Keynesian theory of demand for money?
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2. Derive the liquidity preference curve.

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3. How do credit cards affect the demand for money?

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5.5 DETERMINATION OF EQUILIBRIUM

INTEREST RATE

We found in the previous section that demand for money comes from transaction,
precautionary and speculative motives. The total demand for money is the sum of
money demand arising from all three motives. The transaction and precautionary
demand for money depends on the income level and not on the interest rate,
whereas the speculative demand for money depends on the interest rate. Hence,
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money demand is an increasing function of income (or transactions), but Demand for Money
decreasing function of interest rate due to the speculative nature of demand. Let
demand for money be denoted by 𝑀 , income by 𝑌 and rate of interest by 𝑟. Now
the money demand function is given by,

𝑀 = 𝐿 (𝑌, 𝑟) … (5.8)

The 𝑀 curve is drawn for a given level of nominal income. It depicts the
tradeoff between the demand for money and the rate of interest.
The money supply 𝑀 is determined by the central bank. At equilibrium, money
supply is equal to money demand. That is,

𝑀 = 𝑀 , or

𝑀 = 𝐿 (𝑌, 𝑟) … (5.9)

The money market equilibrium is depicted in Fig. 5.2 below. The demand for
money is negatively sloped and the supply of money is fixed by the central bank.
At 𝑟 ∗ , demand for money is equal to the supply of money. At this interest rate,
given a level of nominal income, people are willing to hold an amount of money
equal to the existing money supply. At interest rates below 𝑟 ∗ , demand for money
exceeds the money supply. Thus, interest rate has to rise so that demand for
money decreases in order to equate money supply The rise in the rate of interest
leads to increase in the demand for bonds and decrease in the money demand.
At interest rates above 𝑟 ∗ , the money supply exceeds the demand for money.
Thus, interest rate has to decline so that demand for money increases, and
equilibrium between demand for and supply of money is achieved. Any
divergence from 𝑟 ∗ tends to autocorrect itself through the mechanism of money
supply and money demand.

Fig. 5.2: Money Market Equilibrium

73
Money in a Modern We now examine how changes in nominal income or money supply affect the
Economy money market equilibrium. For a given interest rate 𝑟 , increase in nominal
income shifts the money demand curve to the right, which is shown in Fig. 5.3
below. That means 𝑀 shifts to 𝑀𝐷 . At 𝑟 interest rate with the new demand
curve 𝑀𝐷 there is excess demand for money. This leads to increase in the
interest rate 𝑟 establishing the new equilibrium at given money supply.

r1

Fig. 5.3: Effect of Increase in Nominal Income

The changes in monetary policy of an economy affect money supply. With given
money demand, an increase in money supply shifts the money supply curve to
the right from 𝑀𝑆 to 𝑀𝑆 as presented in Fig. 5.4. At the initial interest rate 𝑟
with the new money supply 𝑀𝑆 there is excess supply of money. This leads to
fall in the interest rate to attain the new equilibrium at 𝑟 , where 𝑀𝑆 and 𝑀𝐷
intersect each other.

r1

r3

Fig. 5.4: Effect of Increase in Money Supply

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Check Your Progress 4 Demand for Money

1. Explain how equilibrium is attained in the money market. How does an

increase in nominal income affect the money market equilibrium? How
does an increase in money supply affect the money market equilibrium?

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2. Given that 𝑀 = Y (0.35 – i) and Y = 60,000

a) Find the demand for money when the interest rate is 10 per cent.
b) If Y decreases by 50 per cent, what happens to money demand in
percentage terms?

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3. Given that 𝑀 = Y (0.25 – i), 𝑀 = 20 and Y = 100.

a) Find the equilibrium interest rate.
b) At what level should the money supply be set if the central bank wants to
increase interest rate by 10 per cent?

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5.6 LET US SUM UP

In this unit we learnt the relationship between money supply and price level
through the two approaches of the Quantity Theory of Money, viz., Fisher’s
approach and Cambridge approach. The basic conclusion of these approaches is
the same: an increase in money supply results in proportionate increase in the
price level. Also, we learnt about the money demand. There are three motives for
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Money in a Modern people to hold money, viz., transaction motive, precautionary motive, and
Economy
speculative motive. Money demand function is a decreasing function of interest
rate and it is constructed for a given income level. Money supply is fixed by the
central bank. Intersection of money demand and money supply results in
equilibrium in the money market. An increase in nominal income increases the
interest rate, while an increase in money supply decreases the interest rate.

5.7 ANSWERS/HINTS TO CHECK YOUR PROGRESS

EXERCISES

Check Your Progress 1

1. The average money holding decreases, k decreases and V increases.
2. It shifts rightward.

Check Your Progress 2

1. Refer to Sections 5.2 and 5.3
2. Refer to Section 5.3

Check Your Progress 3

1. Refer to Section 5.4.
2. Use Fig. 5.1 for the explanation.
3. People using credit cards can make the payments (or clear all their bills) at the
end of the month rather than each time they undertake a transaction. Hence,
credit cards reduce the average money holdings, thereby reducing the demand for
money.

Check Your Progress 4

1. Refer to Section 5.5 and use Fig. 5.2, Fig. 5.3, and Fig. 5.4.
2. (a)15000
(b) Money demand also decreases by 50 per cent.
3. (a) we have 𝑀 = Y (0.25 – i), 𝑀 = 20 and Y = 100.
As per the equilibrium condition, 100 (0.25– i) = 20.
Thus, i = (25 – 20)/100 = 5 per cent.
(b) For the equilibrium interest rate to be doubled from 5 % to 10%, money
supply should be reduced from 20 to 15.
100 (0.25 – 0.1) = 20 + x. So x = (15 – 20) = – 5.

76
UNIT 6 MONETARY POLICY
Structure
6.0 Objectives
6.1 Introduction
6.2 Objectives of Monetary Policy
6.3 Instruments of Monetary Policy
6.3.1 Quantitative Instruments
6.3.2 Qualitative Instruments
6.4 Monetary Policy in India
6.5 Quantitative Easing
6.6 Let Us Sum Up
6.7 Answers/Hints to Check Your Progress Exercises

*
6.0 OBJECTIVES

After going through this unit, you should be in a position to

 describe the role of a central bank;
 explain the types of monetary policy pursued by central banks;
 identify the objectives of monetary policy; and
 explain the various tools or instruments of conducting monetary policy.

6.1 INTRODUCTION

In Unit 5, we learnt how an increase in money supply leads to a decrease in the

rate of interest. Decrease in interest rate leads to increase in investment, which in
turn leads to increase in aggregate demand, and growth in the GDP of the
economy. A very low rate of interest however would discourage people from
keeping their savings in financial institutions such as banks. The concept of
‘liquidity trap’, as we discussed in Unit 5, may operate at a very low rate of
interest. On the other hand, a high rate of interest will increase the cost of
borrowing (thus cost of production), thereby reducing the demand for credit,
which in turn will reduce the level of investment and economic growth.

Further, looking from the supply side, adequate supply of money facilitates
smooth functioning of the economy while excessive money supply may lead to
inflation. Thus, from a monetary policy perspective, it is important to decide
upon the quantity of money to be supplied since it has repercussions on the rate

*
Ms. Priti Aggarwal, Assistant Professor, College of Vocational Studies, University of Delhi
Money in a Modern Economy of interest which affects the goods market and aggregate demand. It also has
implications on price stability and inflation. In this Unit we will discuss why and
how the supply of money and demand for credit are managed in an economy.
Demand for and supply of money are regulated by certain monetary authority,
usually the Central Bank of the country. The Central Bank of a country, as you
know by now, has several functions to perform. Traditional functions of a central
bank such as the ‘bankers’ bank’ (i.e., the apex bank of a country) and ‘lender of
last resort’ still applies. However, many more functions pertaining to stabilization
of the economy and overall development of the country have come up. In India,
the Reserve Bank of India (RBI) is the apex bank of the country to monitor and
regulate the supply of money and demand for credit. In doing so, the RBI like
other central banks takes into account factors such as economic growth, price
stability, easy access to credit, and smooth functioning of the economy. Monetary
policy is carried out by changing several policy instruments as we will learn later
in the Unit. According to the RBI, it has the following functions:
(i) Formulation of monetary policy;
(ii) Regulation and supervision of the banking and non-banking financial
institutions;
(iii) Regulation of money, foreign exchange and government securities
markets as also certain financial derivatives;
(iv) Debt and cash management for Central and State Governments;
(v) Management of foreign exchange reserves;
(vi) Foreign exchange management – current and capital account
management;
(vii) Banker to banks;
(viii) Banker to the Central and State Governments;
(ix) Monitoring of the payment and settlement systems;
(x) Currency management;
(xi) Developmental role; and
(xii) Undertaking research and collection of statistics.

Along with structural changes of the economy over time, monetary management
of the economy has become very important. The RBI designs and implements the
regulatory policy framework for banking and non-banking financial institutions
with the aim of providing people access to the banking system, protecting
depositors’ interest, and maintaining the overall health of the financial system.
Along with these, management of public debt, management of foreign exchange
rate and foreign exchange reserve, determination of interest rate, maintenance of
inflation rate, and facilitation of high economic growth have become quite
complex.

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 Monetary Policy
6.2 OBJECTIVES OF MONETARY POLICY

Monetary policy is a mechanism through which the supply of and demand for
money in an economy are regulated. Such regulations on supply of and demand
for money are expected to fulfill the objectives of monetary policy. We will
discuss about the objectives or goals of monetary policy in this Unit.

You should note that there is a difference between objectives and targets of
monetary policy. Objectives of monetary policy indicate the direction in which
the policy variables should be aimed at, viz., reducing inflation, achieving full
employment, realizing higher economic growth. On the other hand, targets of
monetary policy are the variables targeted such as money supply, bank credit,
and short term interest rates through the instruments of monetary policy.

A central bank could have a single objective or multiple objectives to follow. The
primary objective of most central banks today is price stability. Price stability
does not mean that there should not be any price rise in an economy. Rather the
objective is to have moderate inflation. Very often, many countries, have come
up with monetary policy that targets inflation rate. Such inflation targeting is
followed in India also (we will discuss about inflation in detail in the next two
units). Inflation targeting was introduced for the first time in 1990 in New
Zealand.

Subsequently many countries such as Canada, United Kingdom, Sweden,

Australia, Chile, Poland, etc. adopted inflation targeting as the objective of
monetary policy during the 1990s. India formally changed the RBI Act and
adopted inflation targeting in 2016. Accordingly, the target variable for monetary
policy in India is an inflation rate of 4 per cent. The RBI formulates monetary
policy in such a manner that inflation rate remains in the range of 2 per cent to 4
per cent per annum.

Prior to 2016, since 1998, India pursued multiple indicators as objectives of

monetary policy. Under this approach the RBI considered a number of target
variables such as money, credit, output, trade, capital flows, fiscal deficit,
inflation rate and exchange rate. We elaborate on some of the major goals of
monetary policy in an economy, so that you get an idea of their importance.

1. Higher Economic Growth

An important objective of the monetary policy is to realize high economic
growth. Economic growth leads to higher per capita income and higher standard
of living for people. As pointed out earlier, higher investment is crucial for
accelerating economic growth. An expansionary monetary policy decreases the
rate of interest and increases investment and output, thus increasing the rate of
growth of the economy.

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Money in a Modern Economy 2. Full Employment Level
Another important objective of an economy is provision of employment to
people. We observe that unemployment of resources, including human resources,
exists in an economy. Further, during recessionary periods, the level of
unemployment increases. Thus there is a need to formulate policies that generates
employment and takes the country towards full employment. At full employment
level of output or potential output, all the factors of production (including labor)
are fully employed. However, this does not imply that there is no unemployment.
Essentially, full employment is associated with a positive rate of unemployment
due to people switching jobs. Such an output is also called full-capacity output.
Monetary policy can help in realization of full-capacity output by influencing
aggregate demand.

3. Price Stability
Price stability, as mentioned earlier, does not mean that prices should remain
constant; it means that the price increase should be moderate. The objective of
price stability may be in conflict with other objectives such as economic growth
and full employment. Any increase in aggregate demand via an expansionary
monetary policy is typically inflationary. If there is shortfall in aggregate
demand, there could be a tendency towards deflation in the economy. Monetary
policy should aim to avoid both inflationary and deflationary situations.

4. Exchange Rate Stability

Monetary policy could affect the balance of payments of an economy via the
interest rate channel. Interest rate plays an important role in foreign investment in
the economy. If there is a decline in the rate of interest, it may result in capital
outflows. Consequently, the demand for foreign currency increases and this
results in the depreciation of domestic currency. Depreciation of currency may
have several consequences – value of domestic currency declines in terms of
foreign currency; foreign goods become more expensive; and import of essential
commodities such as raw materials and inputs may decline which results in
decrease in GDP. As domestic goods and services become cheaper in terms of
foreign currency (due to depreciation), exports of the country may increase which
improves the balance of payments position. The final outcome however depends
on several factors such as elasticity of imports and exports, and global economic
environment (recession, wars, global price levels, etc.).

Check Your Progress 1

1. What are the various objectives of monetary policy?

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80
2. Explain the importance of monetary policy in view of the conflicting Monetary Policy
objectives of an economy.

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6.3 INSTRUMENTS OF MONETARY POLICY

The instruments of monetary policy to control credit are divided into two
categories, viz., Quantitative and Qualitative. Quantitative measures are non-
discriminatory in nature, say for example, when a certain interest rate is set by
the central bank of a country, that rate applies to the banking system of the
country as a whole. In contrast, Qualitative / Selective measures vary from one
section of society to the other.

6.3.1 Quantitative Instruments

The important quantitative credit control instruments of the monetary policy are
as follows:
 Repo Rate
 Bank Rate
 Open Market Operations
 Change in Minimum Reserve Ratio
 Change in Liquidity Ratio
a) Repo Rate
The most noticed and significant instrument of monetary policy is the repo rate.
It is the rate at which commercial banks borrow money from the RBI on
submission of collateral such as securities. Similarly, commercial banks can
deposit their excess reserves in the central bank for which the ‘reverse repo rate’
is applicable. The repo rate is periodically decided by the RBI. Other rates, such
as reverse repo rate, bank rate, and marginal standing facility (MSF) rate get
automatically adjusted as a fixed percentage above repo rate.

The RBI uses repo rate to manage inflation, economic growth and balance of
payments. When inflation rate is high, the RBI can increase repo rate so that
interest rates increase, leading to decline in aggregate demand. On the other hand,
the RBI can decrease repo rate when economic growth is sluggish.

The banks are allowed to borrow from RBI at repo rate under the Liquidity
Adjustment Facility (LAF). Deposit of excess liquidity with RBI is also made
81
Money in a Modern Economy under the LAF. This arrangement helps the bank to manage liquidity pressure and
resolve short term cash shortages. In addition to the LAF, the RBI has ‘Marginal
Standing Facility’ (MSF), which facilitates provision of overnight loans to
commercial banks. The objective is to meet unanticipated shocks such as large
scale withdrawal of cash by customers. The MSF thus receives a penal interest
rate above the repo rate.

b) Bank Rate
Bank rate is the rate of interest at which the central bank provides loans to
commercial banks and other financial institutions. Increase in bank rate has the
effect of increasing the rate of interest in the economy. Similarly, decrease in
bank rate lowers the rate of interest in the economy. Higher bank rate lowers the
extent of credit creation in the economy which leads to a decline in aggregate
demand and hence lower prices. On the other hand, in a recessionary phase a
lower bank rate is proposed.

It is difficult to predict the impact on change in bank rate on bank borrowings.

This is because bank rate itself is not the key lending rate, though is does form
the basis for the multiplicity of RBI’s lending rates charged for different types of
advances. The impact of change in bank rate on bank’s borrowings depends on
various factors such as (a) the degree of bank’s dependence on borrowed
reserves, (b) the sensitivity of the banks’ demand for borrowed reserves to the
differential between their lending rates and borrowing rates (c) the extent to
which other rates of interest have already changed or change subsequently (d) the
state of the demand for loans and the supply of funds from other sources, etc.
Banks are not discouraged from borrowing in the face of higher bank rates if the
market interest rates are high such that banks expect higher returns from
borrowed funds.

There is a subtle difference between repo rate and bank rate. Financial
institutions can borrow from the RBI at the bank rate without submission of any
collateral. On the other hand repo rate is charged for re-purchase of securities
issued by the RBI. Further, bank rate is higher than repo rate.

c) Open Market Operations

The central bank exercises control over the money supply through sale and
purchase of government securities. The term ‘open market operations’ (OMO)
refers to the sale/purchase of government securities by the central bank to/from
the public and banks. While purchase of government securities in open market
increases the high powered money (H), an open market sale of government
securities decreases H by an equal amount.

Following the change in ‘H’, the usual money multiplier (mm) (see Section 4.5,
Unit 4) process leads to change in money supply (M). In order to follow a
contractionary monetary policy to check inflation, the central bank decreases
money supply by selling securities. In a situation of falling prices, the central
bank buys securities for increasing the money supply in the economy. Such an

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expansionary monetary policy helps in boosting aggregate demand and reviving Monetary Policy
the economy from recession.

Open market operations are flexible and reversible in time. Hence, it is

considered to be an efficient instrument of monetary control. Moreover, unlike
bank rate and reserve requirements, it is free from ‘announcement effects’ as no
prior public announcement has to be made to conduct these operations. The direct
effect on H is immediate and the amount of H created or destroyed is precisely
determinable. There are indirect effects also such as interest rate changes.

Purchase and sale of securities in the open market by the central bank or the
monetary authority is popularly known as open market operations. In order to
contract the credit in the economy, the central bank sells securities in the open
market. This leads to fall in aggregate demand and reduction in price level.
Whereas, when credit is to be expanded, there is purchase of securities by the
central bank in the open market. This leads to increase in aggregate demand and
production levels in the economy.

d) Cash Reserve Ratio

A certain fraction of total assets is always kept by banks as cash partially to
comply with the statutory reserve requirements and partially for meeting day-to-
day cash payments. Cash is held as ‘cash on hand’ and as cash balances with the
central bank. These are known as cash reserves of banks which are classified as
‘required reserves’ and ‘excess reserves’.

Banks are statutorily required to hold cash balances with the central bank. In
India, the RBI has the power to impose statutorily ‘cash reserve ratio’ (CRR) on
banks anywhere between 3-15 per cent of the net demand and time liabilities. A
higher CRR implies lower liquidity in the system. Thus when the central bank
plans to increase liquidity in the economy, it decreases the CRR and vice versa.

Cash Reserve Ratio varies across countries. For example, in 2019, it is as high as
45 per cent in Brazil and as low as 1 per cent in the European Union. In India, as
on April 2019, the CRR was 4 per cent. Further, CRR varies over time for the
same country, depending upon the economic environment.

Banks also hold excess reserves, apart from required reserves. These are held in
excess of required reserves. These excess reserves are used to meet the currency
drains, i.e., the net withdrawal of currency by depositors, and clearing drains
which is the net loss of cash due to cross clearing of cheques among banks. Large
part of excess reserves is held as cash on hand, remaining small part is held as
excess balances with the RBI.

By varying the reserve requirements, the RBI uses the CRR as a tool of
controlling money supply. When CRR is raised, banks hold larger cash balances
with the RBI. Since reserves are a part of ‘H’ or high powered money, this
essentially means that a part of H is withdrawn from the public equaling the
amount of additional reserves impounded. On the other hand, lowering of CRR
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Money in a Modern Economy amounts to a virtual increase in H, which results in an increase in money supply
‘M’. In this manner, the CRR serves as an instrument of monetary control. In
case of inflation, CRR is increased, thus decreasing the lending ability of banks.
Alternately, by lowering the CRR, credit expansion by banks increases.

e) Statutory Liquidity Ratio

Besides CRR, banks are also required to meet the statutory liquidity ratio (SLR)
requirements. The RBI Act stipulates that banks are required to hold a certain
fraction of their demand and time liabilities in the form of “liquid assets in their
own vault”. This is called the “Statutory Liquidity Ratio”. Liquid assets include
cash, gold and approved securities, mainly the government securities. Banks
prefer government securities as they earn interest income. The central bank uses
SLR to check the money supply in the economy. Increasing SLR decreases
liquidity in the economy and vice-versa. As on July2019, the SLR rate in India is
18.75 per cent. However, CRR is more actively used by the RBI to manage
liquidity in the economy.

6.3.2 Qualitative Instruments

Qualitative instruments may not lead to changes in volume of money in the

economy. These policy instruments are used for discriminating between different
uses of credit. Thus these instruments are used for regulating credit for specific
purposes. Some of the instruments are as follows:

a) Selective Credit Control

Selective Credit Control relates to qualitative method of credit control by the
central banks. The central bank can take steps to channelize credit to priority
sectors. Similarly, it can impose restrictive measures on credit to certain sectors.
In India, such controls have been used to check speculative hoarding of essential
commodities such as food grains to check their price rise. When credit flow for
purchasing and holding such stocks is restricted, traders increase the market
supply of these commodities and their prices do not increase as much. Hence,
selective credit controls help in moderation of inflation. You will find several
examples of selective credit control in the Indian case. Credit extended to
agricultural sector and small scale industries are instances of selective credit
control.

b) Margin Requirements
The margin refers to that part of the loan amount which the bank does not
finance. For example, if you approach a bank for financing a loan towards
purchase of a house, the bank will not provide loan for the full amount – it may
provide loan for about 80 to 85 per cent of the purchase value. An implication of
the above is that 15 to 20 per cent of the purchase value should be financed from
own funds.

A higher margin on loan discourages borrowing. By changing the margin

requirements, the central bank can encourage credit flow to certain sectors while
restricting it to others. For instance, in order to encourage priority lending to
certain sectors, the government may reduce margin requirements.

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c) Credit Rationing Monetary Policy
In order to restrict credit to certain sectors, the central bank may ration credit by
putting certain limit on the amount the bank can lend to particular sector or
section of society. Through rationing of credit, the central bank can perform the
following tasks:
 It can decline loan to a particular commercial bank
 It can ask commercial banks to extend certain percentage of credit to
priority areas such as agriculture or small scale enterprises.
d) Moral Suasion
Central bank persuades other banks to comply with its policy stance through
discussions, letters and speeches. This is known as moral suasion. Moral suasion
can be employed for both qualitative and quantitative credit control. RBI can
urge banks to keep a large fraction of their assets in the form of government
securities. It can also discourage banks from borrowing excessively during
inflationary periods. These measures help control money supply. Moral suasion
is also used for controlling the distribution of bank credit.

e) Direct Action
Sometimes, the RBI can directly take action against a bank which is not
following its directives and conforming to the broad monetary policy goals. For
example, the RBI may refuse rediscount facilities to such banks or it may charge
a penal rate over and above the bank rate.

Central banks use a mix of different tools for monetary control. Bank rate,
reserve requirements, open market operations and selective credit controls
measures should be adopted simultaneously.

Check Your Progress 2

1. Distinguish between bank rate and repo rate.

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2. What is meant by Liquidity Adjustment Facility?

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85
Money in a Modern Economy 3. Distinguish between quantitative and qualitative measures of credit control.

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6.4 MONETARY POLICY IN INDIA

The policy targets and instruments of the RBI have changed over the years in line
with domestic requirements and global structural changes. In the beginning years,
the Indian economy was in the early stage of development. Thus, there was a
strong need for building infrastructure and enhancing production capacity.
During this phase fiscal policy (use of government revenue and expenditure) was
found to be more important than monetary policy.

In an effort to incur more public expenditure, the government usually ran into
very high levels of fiscal deficit. These deficits were financed by ad hoc treasury
bills or borrowings from public sector banks. Such a method of financing the
deficits was very often inflationary; more so during the 1980s. In order to curb
this tendency, the monetary policy framework changed in 1986 to target the
growth in money supply, particularly M3. After the economic reforms of 1991,
the RBI’s role underwent a significant change. Steps were taken to curb the
monetization of fiscal deficit. Say for example, by 1997 the ad-hoc treasury bills
were completely phased out. However, monetization of fiscal deficit continued
through primary issue of public debt in auctions. In order to stop these methods
of deficit financing, in 2006, the RBI was not allowed to subscribe to the primary
issue of public debt. Since 2016, as mentioned earlier, the sole objective of
monetary policy in India is inflation targeting, at 4 per cent per annum, with a
tolerance band of 2 per cent.

In April 1999, on the recommendations of the Narasimham Committee (second

committee), Interim Liquidity Adjustment Facility (ILAF) was introduced. Repo
and reverse repo rates emerged as the primary policy rates of the RBI and the
significance of CRR and SLR as instruments of RBI to manage liquidity got
reduced. However, the ILAF suffered from non-existence of a ceiling rate and no
unique policy rate. Hence, since May 2011 the repo rate has become the only
independently varying rate under the Revised Liquidity Adjustment Framework
(RLAF).

In 2016, inflation targeting became the sole objective of monetary policy in

India. The Monetary Policy Framework Agreement (MPFA) was signed between
the Government of India (GOI) and the RBI to regulate inflation and bring it
below 4 percent in financial year 2016-17. In case of failure on the part of the
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RBI to comply with the above targets, it is accountable to the government, and Monetary Policy
suggest reasons and remedies to achieve the same in future by a specified date.

6.5 QUANTITATIVE EASING

As you have learnt from Unit 5, when the rate of interest is very close to zero, the
economy enters the liquidity trap region. There could be situations where the
interest rate is low, and the economy is passing through a recession. In such a
situation, there is little scope for further reduction in interest rate; else the
economy would go on to a liquidity trap state. Here, monetary policy is
ineffective and the central bank measures to increase money supply fails. People
are willing to hold whatever amount of money is supplied to them, which leads to
low level of saving in the economy. As a result of low level saving, the level of
investment is low. As you will see in Unit 9, due to low level of investment, there
is a decline in aggregate demand.

In order to circumvent the problem of low interest rate and consequent liquidity
trap syndrome, many central banks resort to a different strategy to boost
economic activity. Here, aggregate demand stops responding to very low interest
rates and consequently, a different policy is sought. Money is directly pumped
into the financial system through a process known as ‘quantitative easing’, which
is also known as asset purchase scheme. Instead of printing money, the central
bank creates electronic money, which is used to purchase bonds and securities
from financial institutions such as banks. When the banks get more liquidity than
what they require as reserves, they make a profit by lending out the excess
reserves.

With quantitative easing, there is an increase in the demand for bonds and
securities. The market price of these bonds increases, which is likely to activate
the bond market and stock markets. With the increase in stock prices, there is a
perception among people that their income and wealth has increased. This is like
to boost aggregate demand through increase in consumption expenditure. Further,
increase in bond prices means a decline in their yields. Lower yields decrease the
cost of borrowing for business which in turn leads to increase in spending and
expands economic activity. This is likely to accelerate investment in the
economy. Banks and financial institutions have more usable funds (due to
injection of funds by the central bank) resulting in increased lending and boosting
business investment and economic activity. When the economy recovers, the
central bank sells these assets and sterilizes the cash it receives from the sales. So
there is no additional money remaining in the system.

The goal of quantitative easing is to inject liquidity into the banking system, so
that banks can lend money to boost economic activity. Quantitative easing aims
to increase aggregate demand while keeping inflation within target bounds.
However, there is a danger of increased inflation through this process.

Amidst the 2008 financial crisis, policy makers were looking for ways for
stabilizing the world economy. One response which emerged in the UK and the
US was ‘quantitative easing’. Both US Federal Reserve and the Bank of England
adopted ‘quantitative easing’ in the aftermath of this crisis. Japan’s central bank

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Money in a Modern Economy first tried ‘quantitative easing’ to control deflation in the Japanese economy in
the 1990s.

Check Your Progress 3

1. Bring out the major changes in monetary policy framework in India.

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2. Explain how ‘quantitative easing’ works.

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3. What is the primary objective of monetary policy in India?

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6.6 LET US SUM UP

Monetary policy pertains to management of the supply of money and demand for
credits. The objective of such controls is to achieve certain goals set for the
economy. The objectives of monetary policy are attained through certain policy
instruments. The policy instruments could be quantitative or qualitative in nature.
The quantitative tools are repo rate, bank rate, open market operations, reserve
requirements, etc. The qualitative tools are selective credit controls, moral
suasion, etc. In a liquidity trap like situation, however, the usual instruments do
not work. Hence, central banks can adopt quantitative easing which injects
liquidity in the banking system and lowers the lending rates of banks.

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 Monetary Policy

6.7 ANSWERS/HINTS TO CHECK YOUR PROGRESS

EXERCISES

Check Your Progress 1

1. The various objectives of monetary policy could be price stability, higher
economic growth, full employment and stable exchange rate. See Section 6.2
for details.
2. Refer to Sections 6.2 and answer. You should point out how various
objectives conflict with one another. You may consider the impact of
decrease in interest rate on various objectives – in what directions it
influences economic growth, unemployment, price stability and balance of
payments.
Check Your Progress 2
1. Repo rate is the rate of interest charged by the central bank on commercial
bank for short term borrowings against submission of collateral. Bank rate is
the rate of interest charged by the central bank on commercial bank
borrowings. Bank rate is higher than repo rate.
2. Short term borrowings (in case of shortage of liquidity) and deposits (in case
of excess reserves) by commercial banks with the RBI are arranged through
the Liquidity Adjustment Facility (LAF).
3. Quantitative measures affect money supply; qualitative measures do not.
Quantitative measures are universal; qualitative measures are sector specific.
Refer to Section 6.3 for details.
Check Your Progress 3
1. Refer to Section 6.4 and answer.
2. Refer to Section 6.5 and answer.
3. Inflation targeting.

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