CHAPTER 8

MONEY MARKET
UNIT 1: THE CONCEPT OF MONEY DEMAND
Definition of Money
To start off, let us first understand what the term money actually means. Money refers
to assets which are commonly used and accepted as a means of payment or as medium
of exchange or transferring purchasing power. Suppose, we want to buy some
vegetables. We pay money to the shopkeeper, hence transferring purchasing power. To
understand the medium of exchange function, let us go back to the barter system. Our
older generations used to exchange goods for goods. This evolved over time to usage of
money. Since money can be exchanged for anything and everything, it is known to be
possessing “generalized purchasing power." Money is totally liquid and is generally
acceptable in settlement of all transactions and in discharge of other kinds of business
obligations including future payments. For example, we can take a loan today on the
promise that we will repay it in money on a future date.
Characteristics of Money
Money can be anything that can serve as a
1. Store of value, which means people can save it and use it later, smoothing their
purchases over time.
2. Unit of account, that is a common base for prices; or
3. Medium of exchange, something that people can use to buy and sell from one
another.
4. Generally acceptable, meaning that money can be exchanged for anything.
5. Durable or long-lasting.
6. Difficult to counterfeit i.e. not easily reproducible by people.
7. Relatively scarce, so that it doesn't lose its value but has elasticity of supply, to
account for interest rate changes.
8. Divisible into smaller parts in usable quantities or fractions without losing value.
Say, a Rs. 100 note can be divided into 10 notes of Rs. 10 without any of the smaller
value notes losing their value.
9. Possessing uniformity.
10. Portable or easily transportable.
11. Effortlessly recognizable.
Functions of Money
1. Act as a medium of exchange state is exchange of goods and services
2. Common measure of value or common denominator of value
3. Serves as a unit of standard of deferred payments and facilities storing of value
both as temporary about purchasing power and permanent store of value.
Fiat Money-
Let us understand what fiat money means, which is the basis of the currency notes
being issued today. Our previous generations, when they moved on from the barter
system, used to exchange silver or gold coins for goods. So, if they wanted to buy a piece
of cauliflower which was worth Rs. 10, they used to give a 10-rupee silver coin, as in, if
the coin were melted, the actual silver would be sold for Rs. 10. Can you guess the
problem in this system? Yes, if the silver price appreciated, what happened to the value
of coins? To counter this problem, fiat money was introduced. Fiat money indicates
that the face value of the currency is greater than its intrinsic value. In simpler
words, if we try and sell the base paper on which a Rs.500 note is printed, it would
hardly yield anything, that is, it is materially worthless.
Demand for Money
Let us understand why knowledge of demand and supply of money is important. Just as
goods and services have demand and supply, similarly, money also has demand and
supply. Just as goods command a price, money also commands a price which is
commonly referred to as general purchasing power. Demand for money is actually
demand for liquidity and demand to store value, which means that the demand for
money is derived demand.
The demand for money is a decision about how much of one's given stock of wealth
should be held in the form of money rather as other assets such as bonds. Although it
gives little or no return individuals households as well as firms hold money because it is
liquid and offers the most convenient way to accomplish their day-to-day transactions.
Basically, people demand money because they wish to have command over real goods
and services with the use of money.
Demand for money has an important role in the determination of interest, prices
and income in an economy.
Theories of Demand for Money
• Classical Approach: The Quantity Theory of Money (QTM)
First propounded by Irving Fisher of Yale University in his book 'The Purchasing
Power of Money' published in 1911, and later by the neoclassical economists. Both
versions of the QTM demonstrate that there is a strong relationship between
money and price level and the quantity of money is the main determinant of the
price level or the value of money.
Fisher's version, also termed as 'equation of exchange' or 'transaction
approach' is formally stated as follows:

MV = PT
Where,
M = the total amount of money in circulation (on an average) in an economy
V = transactions velocity of circulation i.e. the average number of times across all
transactions a unit of money (say Rupee) is spent in purchasing goods and
services.
P = average price level (P= MV/T)
T= the total number of transactions.
(Later economists replaced T by the real output Y).
 Subsequently, Fisher extended the equation of exchange to include demand
(bank) deposits sources of money supply as explained in Unit 2 of this chapter.
Both the central bank and commercial banks are involved in creation of money supply.
(M') and their velocity (V') in the total supply of money. He did this because
there are actually two
Thus, the expanded form of the equation of exchange becomes:

MV +M’V’ = PT
Where,
MV + M'V' PT
M' = the total quantity of credit money
V = velocity of circulation of credit money
Since full employment prevails, the volume of transactions T is fixed in the short
run. Briefly put, the total volume of transactions (T) multiplied by the price level (P)
represents the demand for money. The demand for money (PT) is equal to the
supply of money (MV + M'V)'. In any given period, the total value of transactions
made is equal to PT and the value of money flow is equal to MV+ M'V'. The total
volume of transactions multiplied by the price level (PT) represents the demand for
money.
Both versions of Fisher's theory are based on the concept of equilibrium in
general, where demand for money is equated to supply for money.
 The Cambridge Approach (Neo -Classical Approach: Cambridge Version/Cash
balance Approach)
The Cambridge Approach was propounded by economists A.C. Pigou, J.M. Keynes,
Alfred Marshall, D.H. Robertson.
The Cambridge version holds that money increases utility in the following two
ways:
1. Enabling the possibility of split-up of sale and purchase to two different
points of time. Let us take an example to understand this point. In barter system,
when you wanted to buy any good, you had to give up, that is, sell a particular good
you owned. For example, to buy a chair, I had to give up a cupboard, even though I
might not have thought it appropriate to dispose off the cupboard this early. With
introduction of money, utility was created in the concept where I could buy the
chair and sell the cupboard in two separate transactions, essentially splitting up the
sale and purchase to two different points of time rather than being simultaneous.
2. Being a hedge against uncertainty. Let us say we were to encounter a family
emergency in the future. This is a potential uncertainty which can be hedged against
by storage of money, since it creates utility by being a store of value.
While the first above represents transaction motive, just as Fisher envisaged, the second
points to money's role as a temporary store of wealth. Since sale and purchase of
commodities by individuals do not take place simultaneously, they need a
'temporary abode' of purchasing power as a hedge against uncertainty. As such,
demand for money also involves a precautionary motive in the Cambridge approach.
Since money gives utility in its store of wealth and precautionary modes, one can
say that money is demanded for itself, as in, to encash on a future investment
opportunity.
Now, the question is, how much money will be demanded?
The answer is: it depends partly on income and partly on other factors of which
important ones are wealth and interest rates.
The former determinant of demand i.e. income, points to transactions demand such that
higher the income, the greater the quantity of purchases and as a consequence greater
will be the need for money as a temporary abode of value to overcome transaction
costs. The demand for money was primarily determined by the need to conduct
transactions which will have a positive relationship to the money value aggregate
expenditure.
Since the latter is equal to money national income, the Cambridge money demand
function is stated as:

Md = k PY

Where,
Md is the demand for money balances,
Y = real national income
P = average price level of currently produced goods and services
PY = nominal income
k = proportion of nominal income (PY) that people want to hold as cash balances.
The Cambridge Equation above explains that the demand for money (M) equals k
proportion of the total money income.
Thus we see that the neoclassical theory changed the focus of the quantity theory of
money to money demand and theorized that demand for money is a function of only
money income.
• The Keynesian Theory of Demand for Money
Keynes' theory of demand for money is known as 'Liquidity Preference Theory'.
'Liquidity preference', a term that was coined by John Maynard Keynes in his
masterpiece 'The General Theory of Employment, Interest and Money' (1936),
denotes people's desire to hold money rather than securities or long-term interest-
bearing investments.
According to Keynes, people hold money (M) in cash for three motives:
(i) Transactions motive,
(ii) Precautionary motive, and
(iii) Speculative motive.
 Transactions motive
The transactions motive for holding cash relates to the need for cash for current
transactions for personal and business exchange. It is denoted by
 Where,
Lr, is the transactions demand for money,
k is the ratio of earnings which is kept for transactions purposes, and
Y is the earnings.
Keynes considered the aggregate demand for money for transaction purposes as
the sum of individual demand and therefore, the aggregate transaction demand for
money is a function of national income.
 Precautionary motive
Precautionary motive is to meet unforeseen and un-predictable contingencies
involving money payments and depends on the size of the income, prevailing
economic as well as political conditions, and personal characteristics of the
individual such as optimism/pessimism, farsightedness etc. (Transactions ↑ =>
Precaution ↑)
 Speculative Demand for Money
The speculative motive reflects people's desire to hold cash in order to be equipped
to exploit any attractive investment opportunity requiring cash expenditure.
Speculative demand for money and interest rates are inversely related.
Interest rate ↑ => Speculative demand ↓
Individual's Speculative demand for Money:
When the current rate of interest r, is higher than the critical rate of interest r., the
entire wealth is held by individual wealth-holder in form of Government bonds, since
opportunity cost is minimized by cashing in on the opportunity to earn high interest
from Government bonds. If the rate of interest falls below the critical rate of interest r,
the individual will hold his entire wealth in the form of speculative cash balances. (rn >
rc, then bond prices↑).
Individual’s Speculative Demand

Real Cash Balance: Real Cash balance is the inventory held for transaction purposes.
Aggregate Speculative Demand for Money:
When we go from the individual speculative demand for money to the aggregate
speculative demand for money, the discontinuity of the individual wealth-holder's
demand curve for the speculative cash balances disappears and we obtain a continuous
downward sloping demand function showing the inverse relationship between the
current rate of interest and the speculative demand for money as shown in figure
below:
Concept of Liquidity Trap:
In the adjacent diagram, the
region between M3 and M4 on the
graph, below the curve,
represents the Liquidity Trap
region. We know that as rate of
interest reduces, people want to
hold more balance as speculative
cash, to cash in on opportunities.
However, there comes a point where people do not expect the rate of interest to fall
further, and at that point, they keep without reduction in interest rate, refers to
Liquidity Trap, since people increase their liquid holdings. On an aggregate basis, it
refers to the situation
where money is printed by the central bank not for investment, but as a safeguard
against deflation. Money is printed to increase the money in the hands of the people,
thus increasing aggregate demand, to counter deflation.
Eg: The Bank of Japan's experience is a real-life example of the Keynesian economic
theory of a liquidity trap, in which money printed by a central bank is hoarded in
anticipation of further deflation rather than invested. Japan's 10-year yield dropped to a
record 0.2 percent.
 Post - Keynesian Developments in the Theory of Demand for Money

Baumol and Tobin's Friedman's Restatement of the Tobin's Risk

Inventory Balance Quantity Theory of Money Aversion Theory
Approach

Inventory Approach to Transaction Balances

Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction
demand for money, known as Inventory Theoretic Approach, in which money held for
transaction purposes, or 'real cash balance' was essentially viewed as an inventory held
for transaction purposes.
Inventory models assume that there are two media for storing value:
(a) money and
(b) an interest-bearing alternative financial asset.
People hold an optimum combination of bonds and cash balance, that is an amount that
minimises the opportunity cost.
The optimal average money holding is;a positive function of transactions costs c, and a
negative function of the nominal interest rate I.
(Interest ↑ = opportunity cost ↑ = Bond ↑ Money holding↓)
(Transaction costs ↑ = Money holding ↓)
Friedman's Restatement of the Quantity Theory
Milton Friedman (1956) extended Keynes' speculative money demand theory. It states
that the demand for real money balances increases when permanent income increases
and declines when the expected returns on bonds, stocks, or goods increases. In other
words, when one's permanent income increases, we increase our holding of money for
transaction purposes. When we see an investment opportunity in bonds, stocks or
goods, we reduce our real cash balance.
Factors involved in Friedman's Theory are
1) Permanent income (positive direction).
2) Relative returns on assets (negative direction).
Friedman identifies the following four determinants of the demand for money. The
nominal demand for money:
 is a function of total wealth, which is represented by permanent income divided by
the discount rate, defined as the average return on the five asset classes in the
monetarist theory world, namely money, bonds, equity, physical capital and human
capital.
 is positively related to the price level, P. If the price level rises the demand for
money increases and vice versa.
 rises if the opportunity costs of money holdings (i.e. returns on bonds and stock)
decline and vice versa.
 is influenced by inflation, a positive inflation rate reduces the real value of money
balances, thereby increasing the opportunity costs of money holdings.
The Demand for Money as Behaviour toward Risk (Risk Aversion Theory)
 The Demand for Money as Behaviour toward as 'aversion to risk 'propounded by
Tobin states that money is safe asset but an investor will be willing to exercise a
trade-off and sacrifice to some extent, the higher return from the bonds for
reduction in risk. In other words, he may let go of an expected investment
opportunity in order to reduce the overall risk of his portfolio.
According to Tobin, rational behaviour induces individuals to hold an optimally
structured wealth portfolio which is comprised of both bonds and money and the
demand for money as a store of wealth depends negatively on the interest rate.

MULTIPLE CHOICE QUESTIONS

1. Which of the following is not a use of money:
a) Means of payment. b) Transfer of purchasing
power.
c) Standard of deferred payments. d) None of these.
2. Select the correct definition of legal tender:
a) Means of payment recognized by the IMF.
b) Means of payment recognized by the World Bank
c) Means of payment recognized by the RBI.
d) Means of payment recognized by a legal system.
3. Select the option which is a medium of exchange but not money:
a) Bill of Exchange.
b) Bearer promissory notes issued by RBI.
c) Expired Cheque.
d) None of these
4. Which of the following statements outline the Quantity Theory of Money?
a) There is a direct relationship between purchasing power and general
price level.
b) There is an indirect relationship between purchasing power and general
price level.
c) There is a direct relationship between quantity of money supply and
interest rates.
d) There is an indirect relationship between quantity of money supply and
interest rates.
5. Which of the following examples show money as a standard of deferred
payments
a) Payment of goods on cash basis.
b) Payment of bank charges for cheque clearing.
c) Payment of bank loan.
d) None of these.
6. Demand for money is actually demand for and demand for __________ and demand
for __________
a) Liquidity, Purchasing power.
b) Liquidity, storage of value.
c) Current payment, deferred payments
d) Speculation, property payments.
7. True or False: Demand for money is a factor in deciding interest rates
a) True. b) False.
c) Partly True. d) None of these.
8. Quantity Theory of Money was propounded by:
a) Irving Fisher b) J.M. Keynes
c) Alfred Marshall. d) A.C. Pigou
9. Which of the following is not a motive for holding cash as per J.M Keynes?
 a) Real cash balance
b) Speculation
c) Standard of deferred payments
d) Precaution
10. Which of the following approaches treat cash balance as inventory?
a) Baumol and Tobin Approach
b) Keynesian Approach
c) Classical Approach
d) Marshall Law
11. As per Baumol and Tobin, the more the number of times a bond transaction is
made, the________ will be the average transaction balance holdings.
a) Same b) Lesser
c) More d) None of these
12. Which of the following economists were not involved in the Cambridge
Approach?
a) Alfred Marshall b) J.M. Keynes
c) A.C. Pigou d) Irving Fisher
13. Which of the following functions of money has primarily led to the emergence of
MNCs?
a) Medium of exchange
b) Common measure of value
c) Standard of deferred payments
d) Transfer of value
14. Whose theory for demand for money is commonly referred to as “Liquidity
Preference Theory?"
a) Irving Fisher b) Cambridge Approach
c) J.M. Keynes d) Milton Friedman
15. Which of the following equations correctly denote the Extended Version of
Quantity Theory of Money?
a) MV = PT b) M'V' = PT
+ P'T'
c) MV + M'V' = PT d) None of these
16. Which of the following is not a determinant of demand for money, as per
Friedman's Theory?
a) Total wealth
b) Price level
c) Opportunity cost of money holdings
d) None of these
17. Real cash balance refers to money held for _____________purpose.
a) Speculative b) Precautionary
c) Transaction d) Investment
18. Bond prices and market interest rates have ____________________relation
a) Not a relation b) Inverse
c) Direct d) None of these
Aversion foundation for
19. Risk Aversion Theory provide the foundation for ____________ and ____________
relationship between demand for money and interest rate:
a) Deferred payments, direct
b) Deferred payments, indirect
c) Liquidity preference, indirect
d) Liquidity preference, direct
20. As per Risk Aversion Theory, individual's optimal portfolio structure is
determined by:
a) Risk/reward characteristics of different assets
b) Taste of individual in maximizing his utility consistent with the existing
opportunities.
c) Both of these
d) None of these
21. What would your choice be if you can pay for nearly all transactions through
online transfers?
a) Increase cash demand for money
b) Decrease cash demand for money
c) Both of these
d) None of these
22. A positive inflation rate ________ the real value of money balance, thereby _________
the opportunity costs of money holdings.
a) Reduces, increasing
b) Reduces, decreasing
c) Increases, decreasing
d) Increases, increasing
23. Fiat money refers to the concept where __________value is higher than ________
value.
a) Extrinsic, face b) Intrinsic, face
c) Face, intrinsic d) Face, extrinsic
24. _____________ refers to a situation where Expansionary Fiscal Policy does not
increase interest rates.
 a) Liquidity Trap b) Inflation
c) Deflation d) None of these.

ANSWER KEY
1 (d) 2 (d) 3 (a) 4 (b) 5 (c)
6 (b) 7 (a) 8 (a) 9 (c) 10 (a)
11 (b) 12 (d) 13 (d) 14 (c) 15 (c)
16 (c) 17 (c) 18 (b) 19 (c) 20 (c)
21 (b) 22 (a) 23 (c) 24 (a)
 UNIT - 2: CONCEPT OF MONEY SUPPLY
Money supply means the Total Quantity of money (currency as well as demand deposit)
available to the people in an economy.
The quantity of money at any point of time is a measurable concept.
Supply of money is a stock concept.
Economic stability requires that the supply of money at any time should to be
maintained at an optimum level. A pre-requisite for achieving this is to accurately
estimate the stock of money supply on a regular basis and appropriately regulate it in
accordance with the monetary requirements of the country. In this unit, we shall look
into various aspects related to the supply of money.
Sources of Money Supply
Supply of money in the economy depends on:
1. Decision of the central bank based on the authority conferred on it as central
banks of all countries are empowered to issue currency and therefore, the central
bank is the primary source of money supply in all countries. In effect, high powered
money (issued by RBI) is the source of all other forms of money.
2. The supply responses of the commercial banking system of the country to the
changes in policy variables initiated by the central bank to influence the total
money supply in the economy i.e banking system of the country.
Technology advancements have led to the development of Central Bank Digital
Currencies (CBDCs), and the Reserve Bank of India (RBI) is actively exploring their
introduction. The RBI is implementing a phased strategy, including pilot stages, for the
Digital Rupee (e), aiming to minimize disruptions to the financial system. CBDCs are
defined as digital legal tender, similar to sovereign paper currency but in digital form,
exchangeable at par with existing currency.
In contrast, cryptocurrencies face legal uncertainties in India and are not recognized as
currency. In a notable development, the RBI clarified that banks cannot cite a 2018
order barring them from dealing with virtual cryptocurrencies. This marks a significant
moment in the evolving landscape of digital and traditional currencies.
Measurement of Money Supply
 The measures of money supply vary from country to country, from time to time
and from purpose to purpose.
 Measurement of money supply is essential as it enables framework to evaluate
whether the stock of money in economy is consistent with the standards for
price stability to understand the nature of deviation from the standard and to
study the causes of money growth.
 In India RBI has been publishing data on four alternative measures of money supply
denoted by M1, M2, M3 and M4 besides the reserve money.
Reserve Money = Currency in circulation + Bankers' Deposits with RBI + Other deposits
with RBI
M1 = Currency notes and coins with the people + demand deposits with the banking
system (Current and Saving deposit accounts) + other deposits with the RBI.
M2 = M1 + savings deposits with post office savings banks.
M3 = M1 + time deposits with the banking system.
M4 =M3 + total deposits with the Post Office Savings Organization (excluding National
Savings Certificates).
NOTE: Deposit money of public= Demand Deposit with bank (CASA)+ Other deposits
with RBI.
 New Monetary Aggregates
Following the recommendations of the Working Group on Money (1998), the RBI
has started publishing a set of four new monetary aggregates as: Reserve Money
Currency in circulation + Bankers' deposits with the RBI + Other deposits with the
RBI,
NM1 = Currency with the public + Demand deposits with the banking system +
'Other' deposits with the RBI
NM2 NM1 +Short-term time deposits of residents (including and up to contractual
maturity of one year)
NM3 = NM2+ Long-term time deposits of residents + Call/Term funding from
financial institutions
The Liquidity aggregates are:
 L1 = NM3+ All deposits with the post office savings banks (excluding National
Savings Certificates).
 L2 = L1 +Term deposits with term lending institutions and refinancing institutions
(FIs) + Term borrowing by Fls + Certificates of deposit issued by Fls
Determinants of Money Supply
 The first view, money supply is determined exogenously by the central bank.
 The second view holds that the money supply is determined endogenously by
changes in the economic activities which affect people's desire to hold currency
relative to deposits, rate of interest, etc.
Eg. If people expect any expenses in near future then they may hold more cash in hand.
Hence currency to deposit ratio will be high.
Concept of Money Multiplier
The money created by the Reserve Bank of India is the monetary base, also known as
high-powered money. Banks create money by making loans.
The money supply is defined as
Money is either currency held by the public or bank deposits: M = C + D.
M = m x MB

Where,
M is the money supply,
m is the money multiplier and
MB is the monetary base or high-powered money.
From the above equation, we can derive the money multiplier (m) as
 Money Multiplier (m)=

For instance, if there is an injection of Rs.100 Cr through an open market operation by

the central bank of the country it leads to an increment of Rs.500 Cr. of final money
supply, then the money multiplier is said to be 5. Hence, the multiplier indicates the
change in monetary base which is transformed into money supply.
The multiplier indicates what multiple of the monetary base is transformed into money
supply. In other words, money and high-powered money are related by the money
multiplier.
We make two simplifying assumptions as follows;
 Banks never hold excess reserves.
 Individuals and non-bank corporations never hold currency.
For any value of R,the Money Multiplier is 1/R
For example, if R =10%, the value of money multiplier will be 10. If the reserve ratio is
only 5%, then money multiplier is 20. Thus, the higher the reserve ratio, the less of each
deposit banks loan out, and the smaller the money multiplier.
The Money Multiplier Approach to Supply of Money
The money multiplier approach to money supply propounded by Milton Friedman and
Anna Schwartz, (1963) considers three factors as immediate determinants of money
supply, namely:
(a) the stock of high-powered money (H)
(b) the ratio of reserves to deposits or reserve-ratio r = {Reserves/Deposits R/D}
and
(c) the ratio of currency to deposits, or currency-deposit ratio c={C/D}
a) Behaviour of Central Bank
As per this Approach, Money Supply is determined exogenously by the Central
Bank(Supply of high powered money) Money stock is determined by the money
multiplier and the monetary base (H) is controlled by the monetary authority.
b) Behaviour of Commercial Banks
Commercial banks influence the total money in the economy by creating credit,
determined by the 'reserve ratio' (cash reserves to deposits). If the required
reserve ratio increases, banks reduce loans and deposits, decreasing the money
supply. A lower required reserve ratio allows banks to expand deposits, increasing
the money supply. In practice, banks often keep more reserves than required to
handle unexpected events requiring cash.
The excess reserves (ER) which are funds that a bank keeps back beyond what is
required by regulation form a very important determinant of money supply. 'Excess
reserves' are the difference between total reserves (TR) and required reserves (RR).
Therefore, ER=TR-RR. If total reserves are Rs 800 billion, whereas the required
reserves are Rs 600billion, then the excess reserves are Rs 200 billion.
c) Behaviour of the Public
As we know, demand deposits undergo multiple expansions while currency in
your hands does not. Hence, when bank deposits are being converted into currency,
banks can create only less credit money. The overall level of multiple expansion
declines, and therefore, money multiplier also falls. Hence, we conclude that money
multiplier and the money supply are negatively related to the currency ratio c. Money
Supply is determined endogenously (originating within) by changes in the
economic activities which affect people's desire to hold Currency relative to Deposits,
Rate of Interest etc. (SMALLER THE CURRENCY-DEPOSIT RATIO; LARGER THE
MONEY MULTIPLIER)
Monetary Policy and Money Supply
If the RBI wants to increase economic activity, it needs to inject liquidity into the
system. Say, the RBI purchases government securities under OMO. It injects high
powered money into the system, assuming banks do not maintain excess reserves. The
effect can be summarized as follows:
Money Supply = 1/R* Reserves

Effect of Government Expenditure on Money Supply

Whenever the central and the state governments' cash balances fall short of the
minimum requirement, they are eligible to avail of a facility called Ways and Means
Advances (WMA)/overdraft (OD) facility. When the RBI lends to the governments, it
results in the generation of excess reserves. This happens because, when the
government incurs expenditure, balance of Government with RBI is debited and
receiver's account with a commercial bank is credited.
Credit Multiplier (Deposit Multiplier/Deposit Expansion Multiplier)
It describes the amount of additional money created by the commercial bank through
the process of lending the available money it has in excess of the central bank's reserve
requirements.
Credit Multiplier = 1/ Required Reserve Ratio

MULTIPLE CHOICE QUESTIONS

1. The central bank is allowed to issue currency to any extent
a) By keeping minimum reserve
b) By keeping maximum reserve
c) By following Government guidelines
d) None of these
2. The reserve system of the RBI consists of
a) Gold and government securities
b) Gold and foreign exchange reserves
c) Gold and silver
d) None of these
3. Money created by commercial banks is called
a) Secondary money
 b) Primary money
c) Reserve money
d) Credit money
4. Which of the following denotes the correct formula for M1
a) Currency with public + Other deposits with RBI.
b) Currency with public + Other deposits with RBI + CASA with banks.
c) High powered money + Demand deposits with banks
d) Both b and c
5. Which of the following denotes the correct formula for M2
a) M1 + Post office savings bank deposits
b) M1 + time deposits with banks
c) M4 – Time deposits with banks – Total deposits with post office + Saving
deposits with post office
d) Both a and c
6. Which of the following is the correct formula for net demand deposits
a) Gross demand deposits - Other deposits with RBI
b) Gross demand deposits inter-bank deposits
c) Both of these
d) None of these
7. Two major components of Reserve money are _______ and __________
a) Currency with public; Demand deposits
b) Currency with public; Reserves
c) Both of these
d) None of these
8. Cash Reserve Ratio refers to the proportion of total deposits of commercial
banks which they must keep as __________ reserves with ________.
a) Liquid; Self
b) Cash; Self
c) Cash; RBI
d) Liquid; RBI
9. Statutory Liquidity Ratio refers to the proportion of total deposits of commercial
banks which they must keep as ____________ reserve with ____________
a) Liquid; Self b) Cash; Self
c) Cash; RBI d) Liquid; RB!
10. If NM3 = 10000 crore All Deposits with Post Office 2000 crore and NSC 100
crore, find L1.
a) 12000 crore
 b) 11900 crore
c) 12100 crore
d) 10100 crore
11. Based on Q10, if Term deposits with term lending institutions = 110 crore, term
deposits with refinancing institutions = 20 crore; term borrowings by Fls = 10 crore
; Certificate of deposits issued by Fls = 2 crore ; Public deposits of NBFC = 1 crore ;
Find L2.
a) 12043 crore
b) 12040 crore
c) 12042 crore
d) 12142 crore
12. Based on details from Q10 and Q11, calculate L3.
a) 12044 crore b) 12143 crore
c) 12041 crore d) 12043 crore
13. Identify the correct formula of money multiplier
a) m = Monetary Base/Money Supply
b) m = Money Supply/Money Demand
c) m = Money Supply/Monetary Base
d) m = Money Demand/Money Supply , lower the
14. Higher the _________, lower the ______________.
a) Monetary Base, Money Supply
b) Money Supply, Ratio of currency to deposits
c) Multiplier, Money Supply
d) Money Supply, Money Demand
15. What would be the effect on money multiplier if banks hold excess reserves?
a) Deposits and currency will increase
b) Deposits and currency will decrease
c) No effect on deposits and currency
d) None of these
16. What effect does government expenditure have on money supply?
a) Money supply will decrease
b) Money supply will increase
c) Money supply will remain constant
d) None of these
17. What is the technical name of the loan given by RBI to the Central Government?
a) Current Account
b) Open Market Operations
 c) Trade Window
d) Ways and Means Advances
18. What will be the value of the money multiplier in a system of 100% reserve
banking?
a) Infinity b) 0
c) 1 d) None of
these
19. Credit multiplier is the reciprocal of ______________.
a) MSF Ratio b) LAF Ratio
c) Required reserve ratio d) None of these
20. Total quantity of money available to the people in an economy is called
a) Money demand b) Money supply
c) M1 d) L1
21. If Currency and coins with the public = 20000 crore, CASA with banks = 10000
crore, other deposits with RBI = 1000 crore, Savings deposits with post office
savings banks = 1000 crore and time deposits with banks is 2000 crore, calculate
M2.
a) 34000 crore b) 33000 crore
c) 32000 crore d) 31000 crore
22. As per Q21, calculate M4.
a) 34000 crore b) 33000 crore
c) 32000 crore d) None of these
23. Which of the following is not an impact that money multiplier approach
considers on money supply?
a) Stock of high-powered money
b) Ratio of reserves to deposits
c) Ratio of currency to deposits
d) None of these
24. Which of the following is a factor in determining excess reserves held by banks?
a) Market interest rate b) Expected deposit
outflows
c) Both a and b d) None of these
25. If the behaviour of the public and the commercial banks remains unchanged over
time, the total supply of nominal money in the economy will vary___________ with the
supply of the nominal high-powered money issued by the central bank.
a) Directly b) Indirectly
c) Disproportionately d) None of these
26. If central bank injects more money, it would always be affecting money supply. This
statement is
 a) True b) Partly True
c) False d) None of these
27. Cost and benefits of holding reserves affects excess reserves. This statement is
a) True b) Partly True
c) False d) None of these
28. Which of the following is not a determinant of money supply in a country?
a) Central bank behaviour
b) People behaviour
c) Commercial bank behaviour
d) Government behaviour
29. Compute Reserve Money if Currency in Circulation =`15428.40, Bankers' Deposits
with RBI =`4596.18, Other Deposits with RBI =`183.30
a) 15611.7
b) 20207.88
c) 11015.52
d) None of these
30. What will be the total credit created by the commercial banking system for an
initial deposit of 1000 for required reserve ratio of 0.05?
a) 20000 b) 2000
c) 50 d) None of
these
31. If commercial banks decide to hold more excess reserves, what will happen to
money multiplier?
a) It will decrease b) It will increase
c) It will remain constant d) None of these
32. How will money supply be affected if fearing shortage in ATMs, people decide to
hoard cash?
a) It will decrease b) It will increase
c) It will remain constant d) None of these
33. How will money supply be affected if banks open large no. of ATMs all over the
country?
a) It will decrease b) It will increase
c) It will remain constant d) None of these
34. How will money supply be affected if E banking becomes very common and
nearly all people use them?
a) It will decrease b) It will increase
c) It will remain constant d) None of these
35. How will money supply be affected if during festival season, people decide to use
ATMs very often?
a) It will decrease
b) It will increase
c) It will remain constant
d) None of these
36. How will money supply be affected if banks decide to keep 100% reserves?
a) It will decrease
b) It will increase
c) It will remain constant
d) None of these
37. How will money supply be affected if banks are not required to keep reserves?
a) It will decrease
b) It will increase
c) It will remain constant
d) None of these

ANSWER KEY
1 (a) 2 (b) 3 (d) 4 (d) 5 (d)
6 (b) 7 (b) 8 (c) 9 (a) 10 (b)
11 (c) 12 (d) 13 (c) 14 (b) 15 (c)
16 (b) 17 (d) 18 (c) 19 (c) 20 (b)
21 (c) 22 (b) 23 (d) 24 (c) 25 (a)
26 (c) 27 (a) 28 (d) 29 (b) 30 (a)
31 (a) 32 (a) 33 (b) 34 (b) 35 (a)
36 (c) 37 (b)
 UNIT -3: MONETARY POLICY
As we have only a limited understanding of the monetary phenomena which could
strengthen or paralyze the domestic economy, the discussion that follows is an attempt
to throw light on the well-acknowledged monetary measures undertaken by
governments to flight economic stability.
MONETARY POLICY DEFINED
Reserve Bank of India uses monetary policy to manage economic fluctuations and
achieve price stability, which means that inflation is low and stable. Reserve Bank of
India conducts monetary policy by adjusting the supply of money, usually through
buying or selling securities in the open market. When central banks lower interest rates,
monetary policy is easing. When it raises interest rates, monetary policy is tightening.
MONETARY POLICY FRAMEWORK
The central bank, in its execution of monetary policy, functions within an articulated
monetary policy framework which has three basic components, viz.
(i) the objectives of monetary policy,
(ii) the analytics of monetary policy which focus on the transmission mechanisms,
and
(iii) The operating procedure which focuses on the operating targets and
instruments
OBJECTIVES OF MONETARY POLICY
The objectives set for monetary policy are important because they provide explicit
guidance to policymakers. The monetary policy of a country is in fact a reflection of its
economic policy and therefore, the objectives of monetary policy generally coincide
with the overall objectives of economic policy. Also, there are multiple objectives to
multiple objectives to pursued such as moderate long term interest rates, exchange rate
stability and external balance of payments equilibrium etc. The most commonly
pursued objectives of monetary policy of the central banks across the world are
maintenance of price stability (or controlling inflation) and achievement of economic
growth.
Given the development needs of developing countries, the monetary policy of such
countries also incorporates explicit objectives such as:
(i) maintenance of economic growth,
(ii) ensuring an adequate flow of credit to the productive sectors,
(iii) sustaining a moderate structure of interest rates to encourage investments, and
(iv) creation of an efficient market for government securities.
TRANSMISSION OF MONETARY POLICY
The transmission of the monetary policy describes how changes made by the Reserve
Bank to Its monetary policy settings flow through to economic activity and inflation.
This process is complex and there is a large degree of uncertainty about the timing and
size of the impact on the economy. In simple terms, the transmission can be
summarized in two stages.
1. Changes to monetary policy affect interest rates in the economy.
2. Changes to interest rates affect economic activity and inflation.
Effects of such policy are visible often after a time lag which is not completely
predictable
CHANNELS OF MONETARY POLICY TRANSMISSION (ANALYTICS OF MONETARY
POLICY
Interest Rate Channel
If interest rate rises, cost of borrowing for the firm rises, which reduces investment by
firms and
consumption by households.
Asset Price Channel
Basically, bond prices and equity market are inversely related due to switching to avoid
opportunity cost.
Exchange Rate Channel
Changes in monetary policy lead to appreciation or depreciation of currency thereby
impacting imports and exports.
Expectation Channel
If general expectation of the public is that interest rates will fall, people will expect the
economy to go up, thereby increasing consumption by households and investments by
firms.
Quantum Channel
If policy rate decreases, debt obligation of firms decreases. This increases the strength
of the balance sheet which leads to easier loans from banks. In turn, this leads to higher
investments by firms.
OPERATING PROCEDURES AND INSTRUMENTS
 Quantitative tools -
The tools applied by the policy that impact money supply in the entire economy,
including sectors such as manufacturing, agriculture, automobile, housing, etc.
1. RESERVE RATIO
Banks are required to keep aside a set percentage of cash reserves or RBI
approved assets. Reserve ratio is of two types:
Cash Reserve Ratio (CRR) - Banks are required to set aside this portion in cash
with the RBI. The bank can neither lend it to anyone nor can it earn any interest
rate or profit on CRR.
Statutory Liquidity Ratio (SLR) - Banks are required to set aside this portion in
liquid assets such as gold or RBI approved securities such as government
securities. Banks are allowed to earn interest on these securities; however, it is
very low. SLR LIQUIDITY VICE VERSA.
2. OPEN MARKET OPERATIONS (OMO)
In order to control money supply, the RBI buys and sells government securities in
the open market. These operations conducted by the central bank in the open
market are referred to as open market operations. When the RBI sells government
 securities, the liquidity is sucked from the market and the exact opposite happens
when the RBI buys securities.
 Qualitative tools -
Unlike quantitative tools which have a direct effect on the entire economy's
money supply, qualitative tools are selective tools that have an effect in the
money supply of a specific sector of the economy.
 Margin requirements - The RBI prescribes a certain margin against collateral,
which in turn impacts the borrowing habit of customers. When the margin
requirements are raised by the RBI, customers will be able to borrow less.
 Moral suasion - By way of persuasion, the RBI convinces banks to keep money
securities, rather than certain sectors.
 Selective credit control - Controlling credit by not lending to selective
industries or speculative businesses.
 Market Stabilization Scheme (MSS) –
Policy Rates
 Bank rate - The interest rate at which RBI lends long term funds to banks is referred
to as the bank rate. However, presently RBI does not entirely control money supply
via the bank rate. It uses Liquidity Adjustment Facility (LAF) - repo rate as one of
the significant tools to establish control over money supply.
Bank rate is used to prescribe penalty to the bank if it does not maintain the
prescribed SLR or CRR.
 Liquidity Adjustment Facility (LAF) – RBI uses LAF as an instrument to adjust
liquidity and money supply. The following types of LAF are:
 Repo rate - Repo rate is the rate at which banks borrow from RBI on a short-term
basis against a repurchase agreement. Under this policy, banks are required to
provide government securities as collateral and later buy them back after a pre-
defined time.
 Reverse Repo rate - It is the reverse of repo rate, i.e., this is the rate RBI pays to
banks in order to keep additional funds in RBI. It is linked to repo rate in the
following way:
Reverse Repo Rate = Repo Rate - 1
• Marginal Standing Facility (MSF) Rate - MSF Rate is the penal rate at which the
Central Bank lends money to banks, over the rate available under the rep policy.
Banks availing MSF Rate can use a maximum of 1% of SLR securities.
ORGANIZATIONAL STRUCTURE FOR MONETARY POLICY DECISIONS
It is an agreement reached between the Government of India and RBI on the maximum
tolerable inflation rate that the RBI should target to achieve price stability. The RBI Act
provides for a statutory basis for the implementation of the flexible inflation targeting
framework. The Announcement of an official target range for inflation is known as
inflation targeting. The inflation target is to be set by the Government of India, in
consultation with the Reserve Bank, once in every five years.
Accordingly,
The Central Government has notified 4 percent Consumer Price Index (CPI) inflation as
the target for the period from August 5, 2016 to March 31, 2021 with the upper
tolerance limit of 6 per cent and the lower tolerance limit of 2 percent.
The RBI is mandated to publish a Monetary Policy Report every six months, explaining
the sources of inflation and the forecasts of inflation for the coming period of six to
eighteen months.
The following factors are notified by the central government as constituting a failure to
achieve the inflation target:
a. The average inflation is more than the upper tolerance level of the inflation
target for any three consecutive quarters.
b. The average inflation is less than the lower tolerance level for any three
consecutive quarters.
COMPOSITION OF MONETARY POLICY COMMITTEE

An important landmark in India's monetary history is the constitution of an

empowered six-member Monetary Policy Committee (MPC). It consists of the RBI
Governor (Chairperson), the RBI Deputy Governor in charge of monetary policy, one
official nominated by the RBI Board and central government nominees representing the
Government of India who are persons of ability, integrity and standing, having
knowledge and experience in the field of Economics or banking or finance or monetary
policy.
MPC shall determine the Policy Rate required to achieve the Inflation Target, and which
formulate the Monetary Policy. Thus, with the introduction of the Monetary Policy
Committee, the RBI will follow a system which is more consultative and participative
similar to the one followed by many of the central banks in the world. The new system
is intended to incorporate diversity of views, specialized experience, Independence of
opinion, representativeness, and accountability.

MULTIPLE CHOICE QUESTIONS

1. Which of the following is not an objective of monetary policy?
a) Moderate long term interest rates
b) Exchange rate stability
c) External Balance of Payments
d) Stability of Food Prices
2. Which of the following is not a basic component of monetary policy?
a) Objective of monetary policy
b) Analysis of monetary policy
c) Operational procedure of monetary policy
d) None of these
3. The process through which the evolution of monetary aggregates affects the level
of production and price level is known as
 a) Monetary policy
b) Lending channel
c) Monetary transmission mechanism
d) All of these
4. A contractionary monetary policy _______ the interest rates which in turn __________
the cost of capital for households and firms.
a) Increases, increases
b) Decrease, decreases
c) Increase, decreases
d) Decreases, Increases
5. How do asset prices respond to policy induced increase in short term nominal
interest rates?
a) Increase
b) Decrease
c) Remain constant
d) None of these
6. Tools used by central bank to influence money market and credit conditions are
called:
a) Monetary transmission mechanism
b) Monetary policy tools
c) Monetary policy instruments
d) Central bank directive instruments
7. Which of the following do not constitute direct instrument of monetary policy?
a) Cash reserve ratios
b) Market-based discount window
c) Administered interest rates
d) Credit to priority sectors
8. Which of the following do not constitute indirect instrument of monetary policy?
a) Repo rates
b) Open market operations
c) Standing facilities
d) None of these
9. Higher the CRR with the RBI, ____________ will be the liquidity in the system.
a) Higher
b) Decreases, decreases
c) Increases, decreases
d) Decreases, increases
10. Which of the following do not fall under eligible securities for SLR?
a) Cash
b) Gold
c) Encumbered government securities which are approved.
d) None of these
11. Statutory Liquidity Ratio applies to NBFCs. This statement is
a) True
b) False
c) Partly false
d) None of these.
12. Higher the SLR, ______ the credit creation capacity of a commercial bank.
a) Higher
b) Lower
c) Same
d) None of these
13. Identity the institution to which Liquidity Adjustment Facility is not provided.
a) Scheduled commercial bank
b) Primary dealers
c) Regional Rural Bank
d) All of these.
14. Liquidity Adjustment Facility is availed by dipping into SLR portfolio. This
statement is
a) True
b) False
c) Partly true
d) None of these.
15. Liquidity Adjustment Facility is provided on security of ________
a) Government securities excluding state government securities.
b) Government securities including state government securities.
c) Bills of exchange discounted with the bank
d) RBI’s monetary instruments held with the bank
16. Liquidity Adjustment Facility is provided on a/an _________ basis
a) Daily
b) Weekly
c) Overnight
d) Fortnightly
17. Repo is defined as an instrument for borrowing funds by __________securities with an
agreement to __________ the securities on a mutually agreed future date at an agreed
price which includes interest for the funds.
a) Purchasing, repurchase
b) Selling, repurchase
c) Purchasing, resell
d) Selling, resell
18. The fixed rate quoted for ______ is considered the policy rate.
a) LAF
b) MSF
c) Repo
d) Bank rate
19. The policy rate is the ________ rate of the central bank in a country.
a) Defining
b) Controlling
c) Purchasing
d) Signalling
20. Reverse Repo is defined as an instrument for borrowing funds by __________
securities with an agreement to ___________ the securities on a mutually agreed
future date at an agreed price which includes interest for the funds.
a) Purchasing, repurchase
b) Selling, repurchase
c) Purchasing, resell
d) Selling, resell
21. Bank Rate is linked to _____ rate.
a) Repo b) Reverse Repo
c) MSF d) LAF
22. ____________is used to calculate penalty on default in maintenance of CRR and SLR.
a) Repo rate
b) LAF rate
c) MSF rate
d) Bank rate
23 _____________is the general term used for market operations conducted by the RBI by
way of sale/purchase of government securities to/from the market with an
objective to adjust rupee liquidity conditions in the market on a regular basis.
a) RBI purchase agreement
b) RBI trade agreement
c) Ways and Means Advances
 d) Open Market Operations
24. Which of the following options indicate the correct tolerance rate for inflation as
set by the Central Government?
a) 4%, 6%
b) 2%, 6%
c) 4%, 8%
d) None of these
25. Which of the following is not an overall objective of economic policy?
a) Maintenance of economic growth
b) Ensuring and equate flow of credit to productive sectors
c) Growing the moderate structure of interest rates to encourage
investments
d) Creation of an efficient market for government securities
26. Which of the following do not fall under the three major aspects of operational
procedure of monetary policy in India?
a) Choosing the operating target
b) Choosing the intermediate target
c) Choosing the long term target
d) Choosing the policy instruments
27. Which of the following is not a function of the central bank:
a) Bankers' bank
b) Government's bank
c) Lender of last resort
d) None of these
28. Central Bank is called bankers' bank due to which of the following instruments:
a) Repo, Reverse Repo
b) LAF, MSF
c) Policy rate, bank rate
d) Savings interest rate, current interest rate
29. Which of the following statements correctly explain the statement that the
Central bank is a lender of last resort?
a) It has same relation with other banks in the country as a commercial bank has
with its customer.
b) It provides support to the Government through Ways and Means Advances.
c) It offers loans to banks to cope with the crisis when commercial banks create
liability many times more than the cash reserve and they cannot repay it.
d) None of these
30. Which of the following factors is not noted by the Central Government as
constituting a failure to achieve the inflation target?
a)The average inflation is more than the upper tolerance level for consecutive
three quarters
b)The average inflation is less than the lower tolerance level for consecutive
three quarters
c) Both a and b
d) None of these
31. Number of members in Monetary Policy Committee is
a) 3 b) 4
c) 5 d) 6
32. Which of the following is not covered under Monetary Transmission Mechanism?
a) Interest rate channel
b) Exchange rate channel
c) Quantum channel
d) Asset factor channel
33. Identify the nature of monetary policy undertaken by RBI if it increases repo rate by
50 basis points.
a) Expansionary b) Contractionary
c) Stability d) None of these
34. Identify the nature of monetary policy undertaken by RBI if it reduces cash reserve
ratio.
a) Expansionary b) Contractionary
c) Stability d) None of these
35. Identify the nature of monetary policy undertaken by RBI if it increases the
supply of currency and coins.
a) Expansionary b) Contractionary
c) Stability d) None of these
36. Identify the nature of monetary policy undertaken by RBI if it terminates
marginal standing facility.
a) Expansionary b) Contractionary
c) Stability d) None of these
37. Identify the nature of monetary policy undertaken by RBI if it increases the interest
rates chargeable by commercial banks.
a) Expansionary b) Contractionary
c) Stability d) None of these
38. Identify the nature of monetary policy undertaken by RBI if it sells securities in
the open market.
a) Expansionary b) Contractionary
 c) Stability d) None of these
39. Identify the nature of monetary policy undertaken by RBI if it initiates reverse
repo operation.
a) Expansionary b) Contractionary
c) Stability d) None of these
ANSWER KEY
1 (d) 2 (d) 3 (c) 4 (a) 5 (b)
6 (c) 7 (b) 8 (d) 9 (b) 10 (c)
11 (b) 12 (b) 13 (c) 14 (b) 15 (b)
16 (c) 17 (b) 18 (a) 19 (d) 20 (c)
21 (c) 22 (d) 23 (d) 24 (b) 25 (c)
26 (c) 27 (d) 28 (a) 29 (c) 30 (c)
31 (d) 32 (d) 33 (b) 34 (a) 35 (a)
36 (b) 37 (b) 38 (b) 39 (b)