Money & Central Banking PDF

1 MONEY & CENTRAL BANKING Organization of the Chapter Introduction – 2 Evolution of money – 2 From barter to gold – 2 Debasement – 3 Certificate of gold deposits – initial forms of bank notes – 3 Fractional reserve banking – 4 The emerg...

1 MONEY & CENTRAL BANKING Organization of the Chapter Introduction – 2 Evolution of money – 2 From barter to gold – 2 Debasement – 3 Certificate of gold deposits – initial forms of bank notes – 3 Fractional reserve banking – 4 The emergence of central banks – 5 The creation of fiat money – 6 Definition of money – 8 Features of money – 9 Functions of money – 10 Evolution of payment systems – 10 Central banking in India – 14 Functions of the RBI – 15 Roles of the RBI – 15 Tools of monetary control – 19 The money supply process and the money multiplier – 22 – 24  2 MONEY & CENTRAL BANKING I. INTRODUCTION Money is a part of our everyday life and quite unarguably our life revolves around earning and spending money. This is true for several centuries since the time money has come into existence in any form. Central banking is just a baby in terms of its age compared to money. Nevertheless, in the present era, the central banks define and control (at least presume to) money, its volume, its velocity, its evolution, and all other aspects. Money could be the most important component of a financial system as it acts as the underlying asset for all other financial instruments that are traded through the financial institutions in the financial markets. In this topic of money & central banking, I will first discuss the historical evolution of money and the emergence of central banking as a relevant organization. This discussion is primarily guided by George Cooper’s “The Origin of Financial Crisis”. II. EVOLUTION OF MONEY From Barter to Gold In ancient time, the first trade was conducted via barter. All goods were exchanged directly for all other goods. Goods were produced by those who were good at it, and their surpluses were exchanged for the products of others. Every product had its barter price in terms of all other products, and every person gained by exchanging something he needed less for a product he needed more. In barter, there were severe limitations on the scope of exchange and therefore on production. In the first place, in order to buy something, he wanted, each person had to find a seller who wanted precisely what he had available in exchange. In short, if an egg dealer wanted to buy a pair of shoes, he had to find a shoemaker who wanted, at that very moment, to buy eggs. This crucial element in barter is what is called the double coincidence of wants. A second problem is one of indivisibilities. We can see clearly how exchangers could adjust their supplies and sales of butter, or eggs, or fish, fairly precisely. But suppose that Mr. J owns a house, and would like to sell it and instead, purchase a car, a washing machine, or some horses. How could he do so? Another problem with the barter system is what would happen to business calculation. Business firms must be able to calculate whether they are making or losing income or wealth in each of their transactions. Yet, in the barter system, profit or loss calculation would be a hopeless task. Therefore, the barter system was not a great one, nevertheless we muddled along with barter exchange for a few hundred thousand years. And understandably, this period was not one of rapid economic growth. The first big breakthrough came when everyone agreed to accept gold in return for whatever they were selling. This transition allowed the swapping of rice or eggs or clothes for gold and then gold for anything else. Once gold took on the role of a recognised means of exchange it also inadvertently became a store of value. If in one season you happened to have a lot of wheat, you could swap all of the wheat for gold, spend only part of the gold on bread and items of other necessity, and keep a few nuggets for a rainy day.  3 However, if you happened to have a good harvest and lots of wheat produced, the chances were so would all the other wheat sellers. If everyone tried to sell at the same time, there would be too much wheat chasing too little gold and pretty soon you’d have wheat deflation (a fall in the price of wheat relative to gold), or gold inflation (a rise in the price of gold relative to wheat) depending on your perspective. The emergence of gold’s secondary function as a store of value allowed demand to be transferred through time. Under a gold exchange system there would certainly have been inflation and deflation cycles, sometimes within specific goods and sometimes more generally, most likely linked to harvests, wars, disease and the like. However, since these were cycles, that is prices would go up and then down, on average they would stay more or less the same over very long periods without having any systematic upward trend in the prices. Gradually the economies moved from gold exchange to gold coins through the agreement to divide the gold up into uniform manageable lumps of equal weight and equal purity. The invention of coins made trade easier and encouraged economic expansion. This economic expansion meant that transactions got bigger, so carrying and securing the coins became more troublesome. Debasement An annoying habit of coin clipping also emerged, where people would shave gold from the edges of the coins, and turn these clippings into more coins. This was the start of monetary debasement. It took the genius of none other than Isaac Newton to come up with the idea of milling fine lines onto the edges of the coins, making it easier to detect if the coins had been clipped. While coin clipping was practiced within the private sector, in the state sector monetary debasement took on an industrial scale. Governments, especially when in financial trouble, would recall their coinage, melt it down and reform the metal into more coins with a lower gold content. How debasement profits the State can be seen from a hypothetical case: Say the rur, the currency of the mythical kingdom of Ruritania, is worth 20 grams of gold. A new king now ascends the throne, and, being chronically short of money, decides to take the debasement route to the acquisition of wealth. He announces a mammoth call-in of all the old gold coins of the realm, each now dirty with wear and with the picture of the previous king stamped on its face. In return he will supply brand new coins with his face stamped on them, and will return the same number of rurs paid in. Someone presenting 100 rurs in old coins will receive 100 rurs in the new. However, during the course of this recoinage, the king changes the definition of the rur from 20 to 16 grams. He then pockets the extra 20 percent of gold, minting the gold for his own use and pouring the coins into circulation for his own expenses. In short, the number of grams of gold in the society remains the same, but since people are now accustomed to use the name rather than the weight in their money accounts and prices, the number of rurs will have increased by 20 percent. The money supply in rurs, therefore, has gone up by 20 percent, and, as we shall see later on, this will drive up prices in the economy in terms of rurs. Debasement,  4 then, is the arbitrary redefining and lightening of the currency so as to add to the coffers of the State. Both private sector coil clipping and public sector coin clipping (also called recoinage) caused an increase in the number of coins relative to goods and services produced and therefore inflation. But recoinage was a difficult time-consuming process, which was conducted only occasionally. When it happened there would be a sudden flood of extra money into the system, met by a burst of inflation. However, once the prices had adjusted to the new coinage inflation would stop once more. Certificates of Gold Deposits – Some Form of Bank Notes The next big leap in the development of money was revolutionary and came with the invention of certificates of gold deposits. Debasement, coin clipping and the larger monetary transactions, due to economic expansion, meant that gold coins became difficult to deal with. These problems lead to the development of gold depository banks. Groups of merchants got together to form merchant banks that would hold their gold securely at a central location. The quality of the coinage was checked as it was deposited, and the depositor was issued with a paper certificate of deposit. The certificate of deposit represented his holdings of gold within the bank and the holder of this certificate was entitled to present the certificate back to the bank, who would, on demand, exchange it for the same amount of gold coins originally deposited. The depository banks soon worked out that the merchants who had deposited their gold very rarely came back to collect it. What’s more, the small inflows and outflows of gold that did occur tended, on most days, to cancel one another out. As a result, the bankers found themselves sitting on a large pile of gold coins, which were mostly idle. The bankers started issuing their own certificates of gold deposit, and would lend those certificates to other merchants in need of money. These merchants would use the new certificates to buy goods, which they would then sell on at a profit, and repay the bank before owners of the gold ever realised that their deposits of gold were used to create additional borrowing. At the end of the chain of events the merchant would be left with the profit from his transactions, which he would split with the bankers, in return for their “interest” in the transaction. Even if the transaction took a little longer to complete, the bank would not necessarily be in trouble. Were the second merchant, from whom the goods were bought, to present the bank’s certificate of deposit and ask for the corresponding amount of gold, the bankers would be able to deliver the gold from their pile of idle reserves. This outflow of gold could then be remedied once the first merchant repaid the original loan. By looking at this process a little closer, we need to observe that while the loan is in existence there are more certificates of deposit in circulation than there are gold deposits in the bank. But once the loan is repaid the outstanding certificates are brought back into line with the actual gold reserves. Fractional Reserve Banking This process makes two vital contributions to financial instability. The first and most important being that there were always more certificates of deposit in circulation than there was gold in  5 the vaults of the banks; this is known as fractional reserve banking where the banks would hold a small portion of their outstanding lending as gold reserves. Consequently, the depository banks were not in a position to redeem all their outstanding certificates at once. Second, the banks would open a loan by issuing their own depository certificate to a merchant. However, in the process of performing his trade the merchant was himself likely to receive payment in the form of a depository certificate from another bank. When this certificate was used to repay the loan, the bank would then be left holding a claim on gold held at another bank. Over time the banks would be left with a spaghetti-like network of interlocking claims against one another with number of bank-generated certificates vastly outnumbering those backed by real gold reserves. The financial instability would arise the moment there is a major default by one or several merchants for some exogenous reasons, say a cargo ship sinks in the sea leaving the merchants with huge amount of unpaid debts. The bank which originally lent to the merchant may have quite sufficient of its own capital to write off the value of the merchant’s defaulted loan, but it would not have enough gold in its vaults to redeem all of its outstanding depository certificates. As the word began to spread that merchants were withdrawing physical gold from the bank there will then be a cascade effect, whereby the more gold withdrawn the greater the panic from the remaining certificate holders. This is called a contagion effect. In other words, the bank would suffer a bank run. Naturally, in a situation like this, other banks would cease lending to the troubled institution and would also seek to redeem any certificates of deposit that they happened to hold from the bank. The troubled bank would also try to redeem any notes it happened to hold from other banks for conversion into gold while also attempting to recall any loans made to merchants. These merchants would then either have to seek other funds or quickly raise money by selling their goods and assets. It soon became apparent, through repeated waves of financial crisis, that this new credit generation system was highly unstable. However, it was equally apparent that this new system was also leading to dramatic economic expansion, wealth generation and improving living standards. Equally, the new banking system permitted channels by which risk could be pooled and shared; larger ventures became feasible. It was therefore clearly better to find a way to live with this new system rather than to live without it. III. EMERGENCE OF CENTRAL BANKS The logical thing to do was to create a system to support troubled institutions, and another system of firewalls to prevent trouble at one bank spreading into a general panic throughout the entire system. The answer was a bank for banks – a central bank. The idea was that the central bank would, in the event of a crisis, take over the role of lending to a failing bank. If on the other hand the bank’s loan book had turned bad, then the central bank would force the bank to close, while unwinding the loan book in an orderly manner. For the central bank to be in a position to credibly prevent bank runs it must have and, more importantly must be thought to have, very large and preferably inexhaustible reserves. If the financial community believed the  6 central bank to have virtually limitless resources, then once the bank announced that it was willing to defend any given institution, by honouring its obligations, the bank run would likely abate. The role by which central banks lend to troubled private sector banks is referred to as “lender of last resort”, so named because it was intended that turning to the central bank for finance should only be done once all other avenues for borrowing through the private sector were exhausted. From the above discussion, it becomes clear that the original and primary purpose of central banking is to ensure financial stability of the credit creation system. History shows quite clearly that financial instability came before central banking. This point is well made by examining the events behind the 1907 crisis in America that occurred in the absence of a central bank. It was this crisis that demonstrated the necessity of the central bank and led directly to the formation of the US Federal Reserve System. However, there are certain caveats of the entire process of central banks acting as the lender of the last resort. Firstly, the lender-of-last-resort provided the banks with another potential source of finance, which they could rely upon in the event of a crisis. Naturally this tended to make the banks more confident, and therefore willing to extend more loans. Secondly, because the lender of-last-resort was seen as underwriting all banks equally, depositors and merchants were likely to treat them as being all equally reliable as one another. Rather, the depositors would seek out the banks offering the highest rates of interest on their deposits. However, the banks that could afford to pay the highest rates of interest were likely to be those taking the most risk with depositors’ money. The upshot was that the presence of a lender-of-last-resort created a rush of money toward the riskiest institutions. Central banks were introduced to stabilise the credit system but then found that their presence encouraged more risky lending and inadvertently destabilised it. The presence of a central bank, willing to underwrite all deposits equally, will have the effect of putting safer, less leveraged, institutions at a commercial disadvantage relative to the more cavalier institutions. Over time this will lead to bad lending practices forcing out good lending practice. Today most central banks prefer to downplay the lender-of-last-resort function precisely because advertising this function helps fuel dangerous lending practices. Once again the law of unintended consequences had kicked in; central banks, introduced to stabilize the system, became a source of destabilisation. The solution lied in controlling the banks which led to two changes. One, there will be only one permitted type of depository certificate, and these would be printed by the government, and be distributed through the central bank to the commercial banks. Second, the gold reserves of the commercial banks would be collected together at the central bank. The central bank would control the number of certificates in circulation and monitor the activities of each bank to ensure that no one bank was abusing the lender-of-last-resort facility. The standardization to a single certificate of deposit also simplified the credit system tremendously. All certificates were now equally valuable, even in a crisis.  7 Having taken hold of both the gold reserves for the whole monetary system and of the issuance of certificates of gold deposit (money), the central bank was now the only place where these certificates could be swapped back into gold. The government, through its control of the central bank, now had a monopoly on printing money (certificates of gold deposit) and on exchanging those certificates into real gold. This monopoly power also gave the state the ability to change the amount of gold it was willing to pay out for each certificate in circulation. This move then allowed the government to print itself some more money to pay off its debts. Of course, the extra printed money meant that there was now more money chasing the same amount of goods and services so prices tended to rise, or, equivalently, the value of money tended to fall. This modern-day recoinage exercise was known as devaluing the currency. IV. THE CREATION OF FIAT CURRENCY The next step in the story is the movement from the gold standard to what is known as a “fiat” currency. Fiat money is paper currency decreed by governments as legal Lender (meaning that legally it must be accepted as payment for debts) but not convertible into coins or precious metal. The change into fiat money from gold standard occurred in different countries at different times, with some countries moving away from, and then back onto, a gold standard at different times. However, for the world as a whole, the American story holds great importance and explanation. After the WWII, the world felt the need to formulate a policy to ensure a stable global currency regime that would help all sides rebuild their economic infrastructure. The architecture of the post WWII currency system was decided upon at a conference in the American resort of Bretton Woods, just prior to the end of the war. The structure suggested that all major currencies would be valued against the US dollar at a fixed exchange rate. The value of the US dollar was in turn fixed at a price of $35 per ounce of gold. The combination of fixing all currencies against the dollar and all dollars against gold effectively put the whole world’s currency system onto an agreed gold standard monetary system. The Bretton Woods system worked very well for several decades helping facilitate the rapid reindustrialisation of both Europe and Japan. By the late 1960s, the reindustrialisation outside of America had been so successful that the trade position between America and the rest of the world had reversed; America was now buying more than it was selling. As a result the US was running a trade deficit with the rest of the world, which in turn meant that there was a net outflow of US dollars from America going to the rest of the world to pay for America’s imports. This unbalanced trade and currency flow tended to depress the value of the US dollar. However, under the Bretton Woods agreement non-US countries were obliged to keep the value of their currencies fixed with respect to the US dollar. To maintain these fixed exchange rates foreign governments were obliged to recycle the trade surplus back into America by buying US Treasury bills. Additionally, the Vietnam war was putting the US into ever deeper debt. As it became obvious that the US government could no longer honour the convertibility of dollars into gold some of the more informed of the foreign governments, who were holding US dollars, decided to tender their holdings for conversion into gold. US President Richard Nixon  8 knew that this request for the conversion of foreign reserves into gold could spiral into a bank run in the form of an avalanche of conversion requests, which in the end he could not honour. Consequently, Nixon went for currency devaluation. On August 15th 1971, Nixon announced the closure of the gold window; the US dollar ceased to be a certificate of gold deposit currency. And, as the Bretton Woods agreement pegged all other currencies to gold via the dollar, the rest of the world was also taken off the gold standard. For Nixon this was a masterstroke, as it allowed the US dollar denominated debt to be funded simply by printing more dollars. The advent of fiat money allowed for an entirely new mechanism of monetary creation. Governments had now awarded themselves the right to create their own money without any corresponding liability; since there was no longer a promise to convert the printed money into gold, there was no longer a liability associated with printing that money. With the advent of this new regime, some governments printed more and more money, and used this to increase their spending. The extra government spending pushed up prices, and reduced the spending power of people’s wages. Workers demanded higher wages, companies provided these higher wages by increasing their prices. These higher prices in turn reduced the spending power of the government, who responded by printing itself still more money. After a few years of this inflation spiral it became apparent that the ever-shifting prices were damaging the performance of the economy. Businesses could not reliably forecast costs, or revenues, and therefore cut back on investment; economies stalled, while inflation continued unchecked – stagflation was born. The solution to the inflation problem came about in two ways. Firstly, governments began to accept that they should, and would have to, balance their budgets, bringing expenditure into line with their tax revenue. Secondly, the central banks were given the new responsibility of controlling inflation. This implied that if the government prints extra money to increase its revenue, the inflationary spiral will set in; the central bank then will increase interest rates to curb credit creation and expenditure which will reduce revenue collection through taxes. Therefore, most central banks operate primarily with the dual target of ensuring financial stability and controlling inflation. V. DEFINITIONS OF MONEY Having discussed the evolution of money and emergence of central banking, now let us look at some formal definitions of money. In economics money is defined as anything that is accepted in payments for goods and services and in repayments of debt. The most common usage defines money as the currency consisting of coins and paper money. However, since payment can be made by drawing cheques on savings account, they could also be included in the definition of money. When money represents the wealth of an individual and hence, his/her ability to purchase goods and services, the definition can be even broadened to include time deposits. Consequently, there is a considerable measure of controversy and disagreement about whether to confine the definition of money to the narrow role of serving as the medium of payments or to include those items as well that are close substitutes as a medium of payment.  9 A theoretically oriented answer to this question would aim at a pure definition: money is that good which serves directly as a medium of payments. In financially developed economies, this role is performed by currency held by the public and the public’s chequeable deposits in financial institutions, mainly commercial banks, with their sum being assigned the symbolM1 and called the narrow definition of money. The broad definition that has won the widest acceptance among economists is known as (Milton) Friedman’s definition of money or as the broad definition of money. It defines money as the sum of currency in the hands of the public plus all of the public’s deposits in commercial banks. The latter includes Demand deposits as well as Time deposits with the commercial banks. Demand deposits are deposits which can be drawn on demand and repaid without notice. Demand deposits are primarily of two types: current account and savings account. Current accounts are designed to smooth business transactions. The key features are: i) there is no limit on the number and amount of transactions made per day; ii) banks generally do not give any interest payment on these accounts; iii) banks may apply some service charges; and iv) there is no minimum balance to be maintained. On the other hand, savings accounts i) give interest payments; ii) there are limits on the number and amount of transactions per day; iii) often a minimum balance needs to be maintained; iv) it may or may not provide cheque facility. VI. FEATURES OF MONEY We have also discussed how money has evolved from a barter system to today’s fiat currency. It is to be noted that the process is still evolving. The question is why and how the concept of money might have evolved. A fascinating example of an unexpected development of a money commodity in modern times occurred in German POW camps during World War II. In these camps, supply of various goods was fixed by external conditions: CARE packages, rations, etc. But after receiving the rations, the prisoners began exchanging what they didn’t want for what they particularly needed, until soon there was an elaborate price system for every product, each in terms of what had evolved as the money commodity: cigarettes. Prices in terms of cigarettes fluctuated in accordance with changing supply and demand. Cigarettes were clearly the most “moneylike” products available in the camps. In this context, we will discuss the features a commodity acting as money should have. First of all, individuals do not pick the medium of exchange out of thin air. They will overcome the double coincidence of wants of barter by picking a commodity which is already in widespread use for its own sake. In short, they will pick a commodity in heavy demand, which most people it not everybody will be willing to accept. Second, they will pick a commodity which is highly divisible, so that small chunks of other goods can be bought, and size of purchases can be flexible. For this they need a commodity which technologically does not lose its value when divided into small pieces.It is also important for people to be able to carry the money commodity around in order to facilitate purchases. To be easily portable, then, a commodity must have high value per unit weight. To have high value per unit weight, however, requires a good which is not only in great  10 demand but also relatively scarce, since an intense demand combined with a relatively scarce supply will yield a high price, or high value per unit weight. Finally, the money commodity should be highly durable, so that it can serve as a store of value for a long time. The holder of money should not only be assured of being able to purchase other products right now, but also indefinitely into the future. Therefore, butter, fish, eggs, and so on fail on the question of durability. Cigarettes in the POW camps were ideal to act as money as they were in high demand for their own sake, they were divisible, portable, and in high value per unit weight. They were not very durable, since they crumpled easily, but they could make do in the few years of the camps’ existence. In all countries and all civilizations, two commodities have been dominant whenever they were available to compete as moneys with other commodities: gold and silver. At first, gold and silver were highly prized only for their luster and ornamental value. They were always in great demand. Second, they were always relatively scarce, and hence valuable per unit of weight. And for that reason they were portable as well. They were also divisible, and could be sliced into thin segments without losing their pro rata value. Finally, silver or gold were blended with small amounts of alloy to harden them, and since they did not corrode, they would last almost forever. VII. FUNCTIONS OF MONEY Money performs primarily three functions: 1. Medium of exchange – this is the absolutely essential function of money. This function reduces the transaction cost of exchanging goods and services. The time and money spent while trying to exchange goods or services are called transaction cost. In a barter economy, transaction costs are high because people have to satisfy a "double coincidence of wants"-they have to find someone who has a good or service they want and who also wants the good or service they have to offer. For a commodity to function effectively as money, it has to meet several criteria: (1) It must be easily standardized, making it simple to ascertain its value; (2) it must be widely accepted; (3) it must be divisible, so that it is easy to "make change"; (4) it must be easy to carry; and (5) it must not deteriorate quickly. 2. Unit of account –it is used to measure value in the economy. It also helps in reducing the transaction cost because otherwise the exchange prices of each commodity against all other commodities needed to be mentioned and read out before every purchase. In an n goods economy there will be n (n – 1)/2 numbers of prices to be remembered or referred to before making purchases. Decision making would also have been difficult. This also implied that money introduces easy standardization. 3. Store of value –it is a repository of purchasing power over time. Therefore, money helps us in deferring our transactions. However, there are other assets like gold, property, stocks, bonds etc which also can perform the store of value function while paying the owner often higher interest earnings. But still money is preferred or held because of  11 liquidity; i.e. the relative ease and speed with which an asset can be converted into a medium of exchange. Money is the most liquid asset of all because it is the medium of exchange. Other less liquid assets would entail transaction costs when needed to convert into money for urgent payment. VIII. EVOLUTION OF THE PAYMENT SYSTEM Commodity money - Money made up of precious metals or other valuable commodity is called commodity money, and from ancient times until several hundred years ago, commodity money functioned as the medium of exchange in all but the most primitive societies. The problem with a payments system based exclusively on precious metals is that such a form of money is very heavy and is hard to transport from one place to another. Fiat money - The next development in the payments system was paper currency (pieces of paper that function as a medium of exchange). Initially, paper currency carried a guarantee that it was convertible into coins or into a fixed quantity of precious metal. Paper currency has the advantage of being much lighter than coins or precious metal, but it can be accepted as a medium of exchange only if there is some trust in the authorities who issue it and if printing has reached a sufficiently advanced stage that counterfeiting is extremely difficult. Because paper currency has evolved into a legal arrangement, countries can change the currency that they use at will. Indeed, this is what many European countries did when they abandoned their currencies for the euro in 2002.Major drawbacks of paper currency and coins are that they are easily stolen and can be expensive to transport in large amounts because of their bulk. To combat this problem, another step in the evolution of the payments system occurred with the development of modern banking: the invention of cheques. Cheques - A cheque is an instruction from you to your bank to transfer money from your account to someone else's account when she deposits the cheque. Cheques allow transactions to take place without the need to carry around large amounts of currency. The introduction of cheques was a major innovation that improved the efficiency of the payments system. The use of cheques thus reduces the transportation costs associated with the payments system and improves economic efficiency. Another advantage of cheques is that they can be written for any amount up to the balance in the account, making transactions for large amounts much easier. Cheques are also advantageous in that loss from theft is greatly reduced, and because they provide convenient receipts for purchases. There are, however, two problems with a payments system based on cheques. First, clearance of outstation or inter-bank cheques is time consuming. In addition, if you have a checking account, you know that it usually takes several business days before a bank will allow you to make use of the funds from a cheque you have deposited. If your need for cash is urgent, this feature of paying by cheque can be frustrating. Second, all the paper shuffling required to process cheques is costly. Electronic payment - The development of inexpensive computers and the spread of the Internet now make it cheap to pay bills electronically. It not only saves the postage expenses but also saves time since one does not need to stand in the queue to pay bills.  12 e-Money – it is the money that exists only in electronic form. The first form of e-money was the debit card. Debit cards, which look like credit cards, enable consumers to purchase goods and services by electronically transferring funds directly from their bank accounts to a merchant’s account. More advanced form of e-money is the stored-value card. The simplest form of stored -value card is purchased for a preset dollar amount that the consumer pays up front, like a prepaid phone card. The more sophisticated stored -value card is known as a smart card. It contains a computer chip that allows it to be loaded with digital cash from the owner's bank account whenever needed. A third form of electronic money is often referred to as e-cash, which is used on the Internet to purchase goods or services. A consumer gets e-cash by selling up an account with a bank that has links to the Internet and then has the e-cash transferred to her PC. When she wants to buy something with e-cash, she surfs to a store on the Web and clicks the "buy" option for a particular item, whereupon the e-cash is automatically transferred from her computer to the merchant's computer. The merchant can then have the funds transferred from the consumer's bank account to his before the goods are shipped. Please refer to the RBI page below for definitions of different monetary aggregates. https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?ID=293 Table 1.Monetary Aggregates Reserve =Currency in circulation + Banker’s deposits with the RBI + ’Other’ deposits Money with the RBI (M0) = Net RBI credit to the government + RBI credit to the commercial sector, + RBI’s claims on banks + RBI’s net foreign assets + govt.’s currency liabilities to the public – RBI’s net non-monetary liabilities M1 =Currency with the public + demand deposits with the banking system + ‘Other’ deposits with the RBI M2 =M1 + savings deposits of post office savings banks M3 =M1 + time deposits with the banking system =net bank credit to the govt. + bank credit to the commercial sector + net foreign exchange assets of the banking sector + govt’s currency liabilities to the public – net non-monetary liabilities of the banking sector M4 =M3 + all deposits with post office savings banks (excluding National Savings Certificates) 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 the contractual maturity of one year)  13 NM3 = NM2 + long term time deposits of residents + call/term funding from financial institutions. ‘Currency in circulation’ includes notes in circulation, rupee coins and small coins. Currency with the public is arrived at after deducting cash with banks from total currency in circulation. ‘Bankers’ deposits with the Reserve Bank’ represent balances maintained by banks in the current account with the Reserve Bank mainly for maintaining Cash Reserve Ratio (CRR) and as working funds for clearing adjustments. ‘Other’ Deposits with the Reserve Bank include deposits from foreign central banks, multilateral institutions, financial institutions and sundry deposits net of IMF Account No. 1. (The IMF conducts its financial dealings with a member through the fiscal agency and the depository designated by the member. In addition, each member is required to designate its central bank as a depository for the IMF’s holding of the member’s currency, or if it has no central bank, a monetary agency or a commercial bank acceptable to IMF. Most members have designated their central banks as both the depository as well as the financial agency. The depository maintains without any service charge or commission, two accounts that are used to record the IMF’s holdings of the member’s currency the IMF’s account no. 1 and IMF’s account no. 2 The no. 1 account is used for IMF transactions, including subscription payments, purchases and repurchases and repayment of resources borrowed by IMF.) ‘Net Reserve Bank credit to Government’ includes the Reserve Bank’s credit to Central as well as State Governments. The ‘Reserve Bank’s credit to the commercial sector’ represents investments in bonds/shares of financial institutions, loans to them and holdings of internal bills purchased and discounted. The Reserve Bank’s claims on banks include loans to the banks including NABARD. In case of the new monetary aggregates, the RBI’s refinance to the NABARD, which was earlier part of RBI’s claims on banks, has been classified as part of RBI credit to commercial sector. The Reserve Bank’s net foreign assets are its holdings of foreign currency assets and gold. ‘Government’s currency liabilities to the public’ comprise rupee coins and small coins. ‘Other liabilities of the Reserve Bank’ include internal reserves and provisions of the Reserve Bank such as Exchange Equalisation Account (EEA), Currency and Gold Revaluation Account (CGRA), Contingency Reserve and Asset Development Reserve. Gains/losses on valuation of foreign currency assets and gold due to movements in the exchange rates and/or  14 prices of gold are not taken to Profit and Loss Account but instead booked under a balance sheet head named as CGRA. The balance represents accumulated net gain on valuation of foreign currency assets and gold. CGRA was earlier known as Exchange Fluctuation Reserve (EFR). The balance in EEA represents provision made for exchange losses arising out of forward commitments. Contingency Reserve represents the amount set aside on a year-to-year basis for meeting unexpected and unforeseen contingencies including depreciation in value of securities, exchange guarantees and risks arising out of monetary/ exchange rate policy compulsions. In order to meet the internal capital expenditure and make investments in subsidiaries and associate institutions, a further specified sum is provided and credited to the Asset Development Reserve. ‘Net non-monetary liabilities (NNML) of the Reserve Bank’ are liabilities which do not have any monetary impact. These comprise items such as the Reserve Bank’s paid-up capital and reserves, contribution to National Funds, RBI employees’ PF and superannuation funds, bills payable, compulsory deposits with the RBI, RBI’s profit held temporarily under other deposits, amount held in state Governments Loan Accounts under other deposits, IMF quota subscription and other payments and other liabilities of RBI less net other assets of the RBI. ‘Currency with the public’ is currency in circulation less cash held by banks. ‘Demand deposits’ include all liabilities which are payable on demand and they include current deposits, demand liabilities portion of savings bank deposits, margins held against letters of credit/guarantees, balances in overdue fixed deposits, cash certificates and cumulative/ recurring deposits, outstanding Telegraphic Transfers (TTs), Mail Transfers (MTs), Demand Drafts (DDs), unclaimed deposits, credit balances in the Cash Credit account and deposits held as security for advances which are payable on demand. ‘Time deposits’ are those which are payable otherwise than on demand and they include fixed deposits, cash certificates, cumulative and recurring deposits, time liabilities portion of savings bank deposits, staff security deposits, margin money held against letters of credit if not payable on demand, India Millennium Deposits and Gold Deposits. ‘Net bank credit to Government’ comprise the RBI’s net credit to Central and State Governments and commercial and co-operative banks’ investments in Central and State Government securities. ‘Bank credit to commercial sector’ include RBI’s and other bank’s credit to commercial sector. Other banks’ credit to commercial sector includes banks’ loans and advances to the commercial sector (including scheduled commercial banks’ food credit) and banks’ investments in “other approved” securities. The acronyms NM1, NM2 and NM3 are used to distinguish the new monetary aggregates [as proposed by the Working Group on Money Supply: Analytics and Methodology of Compilation (WGMS) (Chairman: Dr. Y.V. Reddy), June 1998] from the existing monetary aggregates. IX. CENTRAL BANKING IN INDIA  15 India’s financial sector is diversifying and expanding rapidly. It comprises of commercial banks, insurance companies, non-banking financial companies, cooperatives, pension funds, mutual funds and other smaller financial entities. India has a bank dominated financial sector and commercial banks account for over 60 per cent of the total assets of the financial system followed by the Insurance. The financial markets are characterized by various degrees of imperfections which explain the need for regulating the market. The financial system deals with people’s money and therefore, their confidence, trust and faith in it is crucially important for its smooth functioning. Financial regulation is necessary to generate, maintain and promote this trust. The players in a financial system like the savers, investors or the intermediaries may take imprudent risk which could lead to defaults, bankruptcies, and insolvencies. When this happens at a large scale, the entire system and the economy is shaken. Therefore, regulation is needed to check imprudence in the system. Regulations are needed to ensure that the investors are protected; that disclosure and access to information are adequate, timely and equal; that the participants follow the rules of the market; and that the markets are both fair and efficient. The RBI is the regulator of the banking system in India. The organization and functions of RBI are discussed here. The RBI was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act 1934. The Central Office of the RBI was initially established in Kolkata but was permanently moved to Mumbai in 1937. Though originally privately owned, in 1949 the RBI was nationalized and since then fully owned by the Government of India. The Preamble of the RBI describes the basic functions of the RBI as “… to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.” Functions of the RBI The main functions of RBI are, i) To maintain monetary stability – monetary stability broadly refers to stable prices and confidence in the currency ii) To maintain financial stability and ensure sound financial institutions – financial stability is a state where financial markets and institutions are resistant to economic shocks and fit to perform their functions smoothly iii) To maintain stable payment systems - payment and settlement systems play an important role in improving overall economic efficiency. They consist of all the diverse arrangements that we use to systematically transfer money-currency, paper instruments such as cheques, and various electronic channels. iv) To promote the development of financial infrastructure in terms of markets and systems v) To ensure credit allocation according to national economic priorities and social concerns  16 vi) To regulate overall volume of money and credit in the economy. Roles of the RBI Based on the functions it performs, the roles that RBI plays can be broadly described as i) Note issuing authority – the RBI since its inception has the sole authority to issue currency notes other than the one rupee note/coin and coins of smaller denominations. However, all the currencies are put into circulation through RBI only. All affairs related to currency management are conducted through its Issue Department. ii) Government’s banker – Since its inception, the Reserve Bank of India has undertaken the traditional central banking function of managing the government’s banking transactions. The Reserve Bank of India Act, 1934 requires the Central Government to entrust the Reserve Bank with all its money, remittance, exchange and banking transactions in India and the management of its public debt. The Government also deposits its cash balances with the Reserve Bank. The Reserve Bank may also, by agreement, act as the banker and debt manager to State Governments. Currently, the Reserve Bank acts as banker to all the State Governments in India (including Union Territory of Puducherry), except Sikkim. For Sikkim, it has limited agreement for management of its public debt. RBI in its capacity as the banker to the central and state governments provide all banking services such as acceptance of deposits, withdrawal of funds, making payments, receiving payments, managements of public debt and so on. It charges a commission only for debt management where the main idea is to raise resources from the market at a minimum cost in accordance with monetary policy objective. The RBI issues Ways and Means Advances (WAMAs) as temporary loans for a maximum maturity of three months. The WAMA scheme for the State Governments has provision for Special Drawing Facility (SDF) and Normal WAMA. The SDF is extended against the collateral of the government securities held by the State Governments. After the SDF limit is exhausted, the State Government is provided a normal WAMA. The normal WAMA limits are based on three-year average of actual revenue and capital expenditure of the state. The withdrawal beyond the WAMA limit is considered an overdraft. A State Government account can be in overdraft for a maximum of 14 consecutive working days with a limit of 36 days in a quarter. The management of providing the overdraft facility is a major responsibility of the RBI. The interest charged on overdrafts is very high. The rate of interest on WAMA is linked to the Repo Rate. Surplus balances of State Governments are invested in Government of India 14-day Intermediate Treasury Bills automatically in accordance with the instructions. Under the administrative arrangements, the Central Government is required to maintain a minimum cash balance with the Reserve Bank. Under a scheme introduced in 1976, every ministry and department of the Central Government has  17 been allotted a specific public sector bank for handling its transactions. Hence, the Reserve Bank does not handle government’s day-to-day transactions as before, except where it has been nominated as banker to a particular ministry or department. As banker to the Government, the Reserve Bank works out the overall funds position and sends daily advice showing the balances in its books, Ways and Means Advances granted to the government and investments made from the surplus fund. iii) Bankers’ bank – Like individual consumers, businesses and organizations of all kinds, banks need their own mechanism to transfer funds and settle inter-bank transactions such as borrowing from and lending to other banks-and customer transactions. As the banker to banks, the Reserve Bank fulfills this role. Banks are required to maintain a portion of their demand and time liabilities as cash reserves with the Reserve Bank. For this purpose, they need to maintain accounts with the Reserve Bank. They also need to keep accounts with the Reserve Bank for settling inter-bank obligations, such as, clearing transactions of individual bank customers who have their accounts with different banks or clearing money market transactions between two banks, buying and selling securities and foreign currencies. RBI controls the volume of banks’ reserves and their ability to create credit. It also acts as the lender of the last resort. It can come to the rescue of a bank that is solvent but faces temporary liquidity problems by supplying it with much-needed liquidity when no one else is willing to extend credit to that bank. The Reserve Bank extends this facility to protect the interest of the depositors of the bank and to prevent possible failure of the bank, which in turn may also affect other banks and institutions and can have an adverse impact on financial stability and thus on the economy. iv) Supervising authority – RBI provides the broad parameters within which the banks and the financial system function in India. This include 1) issue of licenses for new banks/bank branches; 2) prescription of minimum requirements of reserves, liquid assets etc. 3) inspection of the working of the banks in terms of their organizational set up, branch expansion, deposit mobilization, investment and credit portfolio management, region-wise performances, profit planning, man power planning and training and so on; 4) conduct of ad hoc investigations from time to time of complaints, irregularities and frauds; 5) to control appointment/reappointment/termination of appointment of chairman/CEOs of private banks; and 6) to approve/force amalgamations/reconstruction/liquidation of banks. v) Exchange control authority–RBI has the responsibility of developing and regulating the foreign exchange market. It is the custodian of India’s foreign currency reserves. It has the authority to enter into foreign exchange transactions on its own account as well on behalf of the government. vi) Promoter of the financial system – in this role the RBI has done a commendable job by diversifying the institutional structure of the Indian financial system. For  18 instance IFCI, IDBI, SFCs, IIBI, Exim Bank, SIDBI, NABARD etc. were created with concessional financial support which were later phased out for most of them. The origin, current status and functional areas of these DFIs (Development Financial Institutes) are discussed below briefly. IFCI – Industrial Finance Corporation of India was the country’s first DFI to be set up on July 1, 1948 and was initially funded by the RBI. With the changing economic and financial scenario in the 1990s, IFCI was brought under the Companies Act 1956 and converted into a public limited company in 1993. However, GoI still is the majority shareholder of the company accounting for 70.32 percent of its equity capital as till September, 2023. IDBI – Industrial Development Bank of India, though initially constituted as a DFI, was converted into a bank in 2004 and a new company under the name of Industrial Development Bank of India Limited (IDBI Ltd.) was incorporated as a Govt. Company. As a DFI, the erstwhile IDBI extended its operations beyond mere project financing to cover an array of services that contributed towards balanced geographical spread of industries, development of identified backward areas, emergence of a new spirit of enterprise and evolution of a deep and vibrant capital market. As of November 2023, promoter and promoter groups (President of India and LIC) hold 94.72 percent of its total number of shares. SFCs – the State Financial Corporations are designed to promote small and medium industries of the states to ensure balanced regional development, higher investment, and more employment generation. The State Governments are in charge of appointing the managing directors, generally in consultation with the RBI. Presently, there are 18 SFCs in India. IIBI– the Industrial Reconstruction Corporation of India Ltd. was set up in 1971 for rehabilitation of sick industrial companies, was reconstituted as Industrial Reconstruction Bank of India in 1985 and further incorporated under the Companies Act 1956 as Industrial Investment Bank of India Ltd. (IIBI) in March 1997. IIBI was a 100% government of India-owned financial investment institution. However, huge percentage of non-performing assets accumulated over a long period of time, rendered this institution non-viable. Consequently, the bank was closed down in 2006 – 2008. Exim Bank - Established by the Government of India, the Export-Import Bank commenced operations in 1982 as a purveyor of export credit. The product and services offered include import of technology and export product development, export production, export marketing, pre-shipment and post-shipment and overseas investment. SIDBI – The Small Industries Development Bank of India was set up in 1990 to act as the principal financial institution for financing, promotion, development and coordination of MSMEs. It began its operations by taking over the outstanding  19 portfolio and activities of IDBI pertaining to small scale sector. As on May 04, 2022, SIDBI has 23 banks, insurance companies and other investment and financial institutions as its shareholders all of which are owned or controlled by GoI. Government of India has 20.85 percent shareholding of SIDBI. NABARD – the National Bank for Agriculture and Rural Development came into existence in 1982 with an initial capital of ₹ 100 crore. Consequent to the revision in the composition of share capital between Government of India and RBI, the paid up capital as on 31 March 2020, stood at 14080 crore with Government of India holding 100% of it. NABARD mission is to promote sustainable and equitable agriculture and rural prosperity through effective credit support, related services, institution development and other innovative initiatives. The authorized share capital is ₹30,000 crore which was revised in March 2017. vii) Regulator of money and credit – RBI formulates and conducts monetary policies. Monetary policy refers to the use of the techniques of monetary control to achieve the broad objectives of i) maintaining price stability and ii) ensuring adequate flow of credit to productive sectors. The important tools of monetary control are, a) open market operations (OMO), b) bank rate, c) cash reserve ratio (CRR), d) statutory liquidity ratio (SLR), e) liquidity adjustment facility (LAF), f) standing deposit facility rate, and g) Market Stabilization Scheme (MSS). These instruments are discussed below. Tools of Monetary Control Tools of monetary control can be divided into two types: direct and indirect tools or instruments. The term “direct” refers to the one-to-one correspondence between the instrument and the policy objective. Direct instruments operate by setting or limiting either prices (interest rates) or quantities (amounts of credit outstanding) through regulations, while indirect instruments act through the market by, in the first instance, adjusting the underlying demand for, and supply of, bank reserves.The most common direct instruments are interest rate controls, credit ceiling and directed lending, i.e. lending at the behest of the authorities, rather than for commercial purposes. The three main types of indirect instruments are open market operations, reserve requirements and central bank lending facilities. In India during the 1990s, in response to a changing financial and overall economic landscape, the RBI gradually shifted from the direct instruments to the indirect instruments of monetary control. Credit ceiling was removed though directed lending was retained. Interest rates were freed except for the saving deposit rates, some NRI deposit rates and certain lending rates where the loan amount was below ₹ 2 lakhs. Automatic monetization of budget deficit was also discarded. Yields on government securities were made market determined while pricing of issues in the primary market was freed. Foreign exchange rates were also made market determined with full convertibility of rupee on the current account. The SLR was also reduced from a maximum of 38 percent in 1993 to 25 percent by 1997. Finally, the monetary policy moved to a multiple indicator approach in 1998-9 wherein the  20 information contained in interest rates and the rates of returns in different markets along with currency, credit, fiscal position, trade, capital flows, inflation rate, exchange rate, all were taken into consideration for drawing policy perspectives. The major policy instruments actively used by the RBI are discussed below. Repo Rates & Reverse Repo Rates Repo is a useful money market instrument enabling the smooth adjustment of short term liquidity among banks and financial institutions. Repo refers to a transaction in which a participant acquires immediate funds by selling securities and agrees to repurchase the same after a specified time at a specified price. Thus, it is a short term collateralized borrowing/lending through exchange of debt instruments. The maturity period of repos ranges from 1 to 56 days. In reverse repo one party buys securities from another party for additional income from idle cash. Since repos are securitized, they are safer than call/notice money. They are used by central banks as instruments of monetary control. Repo implies injection of liquidity and reverse repo implies absorption of liquidity. Currently, the repo and reverse repo rates are 6.5% and 3.35%, respectively. There are two types of repos in operation – market repos and RBI repos. Market repos are repo transactions among banks and primary dealers in eligible govt. securities. RBI repos are the mechanism through which RBI lends money to banks against govt. securities. Alternatively, when banks need money they can borrow from the RBI at the repo rate and they can park their extra funds with the RBI at reverse repo rate. Reverse repo is the rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF. Repo rates are of two types: overnight repo refers to repos with maturity period of one day and when maturity is more than one day it is called term repo. When the RBI wants to ease the liquidity situation, it may lower the repo rate. Liquidity Adjustment Facility (LAF) The RBI uses an array of facilities to relieve liquidity shortages in the economy. For instance, RBI’s export credit refinance (ECR) facility was extended to scheduled commercial banks on the basis of their eligible outstanding rupee credit both at the pre-shipment and post-shipment stages. However, these facilities have been gradually phased out and LAF was introduced on June 5, 2000 as a tool for day to day liquidity management for injection or absorption of liquidity through purchase or sale of securities. In 1998 the Committee on Banking Sector Reforms (Narasimham Committee) recommended the introduction of LAF under which the RBI would conduct auctions periodically of repo and reverse repo. This allowed the RBI to reset the repo and reverse repo rates which would provide a reasonable corridor for the call money rate. In the implementation of LAF, the RBI first introduced an Interim LAF by bringing in collateralized lending facility (CLF) up to 0.25 percent of the fortnightly average outstanding aggregate deposits in 1997-98 for two weeks at the bank rate. Further, an Additional CLF (ACLF) for an equivalent amount of CLF was made available at the bank rate plus 2 percent. CLF and ACLF availed for beyond two weeks were subjected to a penal rate of 2 percent for  21 an additional two-week period. Later with the introduction of full-fledged LAF in June 2000, ACLF and CLF were replaced gradually with variable rate repo auctions. Repo/reverse repo auctions are conducted on a daily basis except on Saturdays and Sundays with a tenor of one day except on Friday and days preceding holidays. Repo and reverse repo rates are decided through cut off rates emerging from auctions conducted by the RBI. The RBI has introduced variable rate repos auctions for overnight as well as term repos extending up to 56 days. The RBI also conducts variable interest rate reverse repo auctions. Scheduled commercial banks and primary dealers holding accounts with RBI are eligible to use the LAF. Standing Deposit Facility (SDF) Rate The rate at which the Reserve Bank accepts non-collateralized deposits, on an overnight basis, from all LAF participants. The SDF is also a financial stability tool in addition to its role in liquidity management. The SDF rate is placed at 25 basis points below the policy repo rate. With the introduction of SDF in April 2022, the SDF rate replaced the fixed reverse repo rate as the floor of the LAF corridor. Marginal Standing Facility (MSF) RBI introduced MSF for liquidity adjustment with effect from May 9, 2011, where eligible scheduled commercial banks can avail overnight loan up to one percent of their NDTL (net demand and time liabilities) excluding SLR by pledging all SLR-eligible securities. The minimum amount of credit should be Rs 1 crore and in multiple of Rs 1 crore thereafter. Currently MSF rate is 6.75%, 25 basis points higher than the repo rates. Bank Rate Bank rate is the rate at which the RBI buys commercial papers and makes advances on specified collaterals to banks. An increase (decrease) in the bank rate would lead to an increase (decrease) in the lending rate by the banks and hence, a decrease (increase) in the volume of credit. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes. Prior to 1997, bank rate was not frequently used as an effectively monetary policy tool. Post 1997 it has been reactivated and now it acts as a signal for banks to revise their loan prices. Cash Reserve Ratio (CRR) RBI prescribes the CRR as an average daily balance as a percentage of demand and time liabilities of banks. Default in maintenance of CRR is liable to penal interest on the amount of shortfall. Currently, CRR is 4.5 percent. The major monetary policy changes included a reduction in CRR from a maximum of 15 percent in 1989 to 5 percent by 2004. Statutory Liquidity Ratio SLR is the ratio of cash in hand (excluding CRR), balances in current account with banks and RBI, gold and approved securities (mostly govt. securities) to the total demand and time liabilities (DTL) of the bank. Alternatively, SLR refers to mandatory investment in gold and  22 government securities as a percentage of their total DTL. It is the liquid assets that banks have to hold as a percentage of their total DTL. The objectives of SLR are i) to restrict expansion of bank credit, ii) to augment banks’ investments in government securities and iii) to ensure solvency of banks. The SLR defaults result in restrictions on the access of refinance from RBI, higher costs of refinance and penal interest payment in excess of bank rate on the shortfall amount. An increase in the SLR does not restrain total expenditure in the economy. Rather, it favours public sector expenditure at the cost of private sector expenditure. The converse is true for a decrease in SLR. Presently, SLR is 18 percent. Open Market Operations OMOs refer to the sale and purchase of securities of the central and state governments and T- bills by the RBI. The major objectives are i) to control money supply through banks’ reserves, and ii) to support the government’s borrowing programme. In India OMOs are conducted only through central govt. securities and often are not used as a monetary policy tool. RBI mostly buys securities on switching operations where long term securities are exchanged for short term securities. It is primarily used as a debt management tool. Nevertheless, increase in the net sales of govt. securities through OMOs has helped in regulating credit flows in the banking sector. Market Stabilization Scheme (MSS) This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated government securities and treasury bills. The cash so mobilised is held by the government in a separate identifiable cash maintained and operated by the RBI. The amounts credited into the MSS account would be appropriated only for the purpose of redemption and/or buy back the T-bills or govt. dated securities issued under the MSS. Under the MSS, the securities are issued through auctions by the RBI and they are treated as eligible for SLR, LAF and repo. The payment for interest and discount for MSS securities are not made from the MSS accounts. The receipts due to premium and/or accrued interest are also not credited to the MSS Account. MSS has considerably strengthened the RBI’s ability to conduct exchange rate and monetary management operations. Generally, the preference is given to short term instruments to have a greater degree of freedom in liquidity management. With demonetization on November 8, 2016 of ₹500 and ₹1000 notes the cash holdings with the banks increased significantly. Consequently, on December 02, 2016 RBI revised the ceiling for issue of securities under MSS to ₹ 600,000 crore (₹ 6000 billion) from the earlier ceiling of ₹ 30,000 crore for 2016-17. It has been further revised downward in April 2017 to ₹ 1000 billion for 2017-18. Since December 2016, frequent transactions of CMBs and T-bills have been conducted by the RBI under the MSS till May 2017. The last auction under MSS window was conducted on May 08, 2017. Prior to that, between July 2009 and December 2016, MSS window was not used by the RBI. X. THE MONEY SUPPLY PROCESS AND MONEY MULTIPLIER  23 There are three players in the money supply process: namely, the central bank, the banks (depository institutions) and the depositors, i.e. the individuals and institutions that hold deposits with the banks. The central bank is the most important entity in the money supply process. Its conduct of monetary policy affects its balance sheet which consists of its holdings of assets and liabilities. Consider a simplified balance sheet as follows: The Central Bank Balance Sheet Assets Liabilities Securities Currency in circulation Loans to financial institutions Reserves The asset side must equal the liabilities side. The two liabilities in the balance sheet are important part of the money supply process because change in either or both will lead to a change in the money supply in the economy (everything else being constant). In most countries they form the monetary base or base money or reserve money. Reserves or Bankers’ deposits with the RBI in India consist of required reserves as dictated by the central bank through CRR and excess reserve, which is any amount of reserves that the banks hold in excess of their reserve requirement with the central bank (defined in the previous topic). Assets are also important in the money supply process, since changes in assets lead to changes in reserves and hence, changes in the money supply. Additionally, assets earn much higher interest income than liabilities (reserves). Securities include primarily govt. securities which the central banks sell or purchase from the banks to control liquidity in the economy through changes in the reserves. On the other hand, the banks and other financial institutions can take loans from the central bank known as ‘borrowed reserves’. These loans appear as liabilities in the financial institutions’ balance sheets. An increase in loans increases money supply. Thus, the central bank can exercise control over the monetary base through various monetary policy tools discussed above. Now let us consider OMO as a tool to bring changes in liquidity position. If the central bank goes for open market purchase of, say Rs 100 million, then its assets increase by additional securities worth Rs 100 million while its reserves increases by Rs 100 million. On the other hand, for the commercial banks as a whole only the asset side of the balance sheet will change. There will be –Rs 100 million in securities and + Rs 100 million in reserves. If say Rs 50 million is loaned out then reserves decrease by Rs 50 million while on the asset side itself loans are added worth Rs 50 million. Change in Banking System’s Balance Sheet Assets Liabilities Securities (-Rs 100 million)  24 Reserves (+ Rs 100 million) Or Assets Liabilities Securities (-Rs 100 million) Reserves (+ Rs 50 million) Loans & Advances (+Rs 50 million) With increase in their reserves banks create deposits through loans and advances. A chain of deposit creation follows every time a cheque is issued to the creditor (in a simplistic framework). Alternatively, if the banks purchase securities then also the process will be similar starting with writing cheques for the seller of securities. Thus, one can obtain a simple deposit multiplier as ∆𝐷 = × ∆𝑅 where rr is the CRR, D is total demand deposits and R is total reserves = required reserves (assuming that banks do not hold excess reserves). Let us take a simple example to show how this happens. Assume that a bank receives an addition of Rs 1000 in his reserves. If the CRR is 0.10, then the bank loans out Rs 900 after keeping aside 10 percent as required reserve. In this process of lending the amount the bank creates a loan account of the creditor. The creditor while spending the money draws a check in the name of the receiver which the receiver deposits in a bank and the bank creates an account in the name of the depositor. However, the bank in the second stage further loans out this increase in reserve by setting aside 10 percent as required reserves. Thus, in the second stage the loan amount is Rs 810. This process continues. The amounts of deposits created are shown in the following table. This shows that the total amount of deposit creation (which forms creation of money or money supply) is 10 times the original increase in the reserves (approximately) as suggested by the simple deposit multiplier, 1/rr, discussed above. Therefore, the concept of money multiplier tells us how much the money supply changes with a change in the monetary base. Since the money multiplier is large than one, one percent increase in monetary base leads to manifold increase in the money supply. That is why monetary base is also referred to as high-powered money. Loan Loan Loan Loan Loan CRR amount CRR amount CRR amount CRR amount CRR amount 1000 38.74 348.68 13.51 121.57 4.71 42.39 1.64 14.78 100 900 34.87 313.81 12.16 109.41 4.24 38.15 1.48 13.3 90 810 31.38 282.43 10.94 98.47 3.82 34.33 1.33 11.97 81 729 28.24 254.19 9.85 88.62 3.43 30.9 1.2 10.77  25 72.9 656.1 25.42 228.77 8.86 79.76 3.09 27.81 1.08 9.69 65.61 590.49 22.88 205.89 7.98 71.78 2.78 25.03 0.97 8.72 59.05 531.44 20.59 185.3 7.18 64.6 2.5 22.53 0.87 7.85 53.14 478.3 18.53 166.77 6.46 58.14 2.25 20.28 0.79 7.06 47.83 430.47 16.68 150.09 5.81 52.33 2.03 18.25 0.71 6.35 43.05 387.42 15.01 135.08 5.23 47.1 1.83 16.42 9942.59 However, the problem with the above multiplier is that in reality every transaction does not lead to creation of demand deposits. The loaned amount can be completely spent by drawing cash or partly in terms of checks, partly in cash. Therefore, a more realistic money multiplier will be usually less than 1/rr and can be derived using the following formulae. Required reserves, excess reserves, and currency in circulation, all can be expressed as certain percentage of checkable deposits. RR = r × D ER = e × D C=c×D MB = RR + ER+ C = (r × D) + (e × D) + (c × D) = (r + e + c)×D D = MB / (r + e + c) Where RR = required reserve; ER = excess reserve; D = checkable deposits; r = CRR (in India); e = ratio of excess reserve to demand deposits; C= currency in circulation; c = ratio of currency to checkable deposits; and,MB = monetary base. Now, consider the narrow or M1 definition of money (defined in Table 1) where M = C + D = (c × D) + D = (1 + c) × D M= × MB Here is the money multiplier denoted by m. If e = 0, the multiplier reduces to , the most commonly used one. Since, both r and c are fractions, the denominator is smaller than the numerator and hence, the multiplier is larger than one. References Alexander, William E., Balini, Tomas J. T., and Enoch, Charles (1996). Adopting Indirect Instruments of Monetary Policy. Finance & Development, March 1996, 14 – 17.  26 Mishkin, Frederick S. 2019. The Economics of Money, Banking, and Financial Marker, Twelfth Edition. Pearson Education, UK. Cecchetti, Stephen G. & Schoenholtz, Kermit L. Money, Banking, and Financial Market, fifth edition. McGraw Hill, New York, 2017. Mohan, Rakesh. Monetary Policy in a Globalized Economy. Pathak, Bharti. Indian Financial System. Cooper, George. The Origin of Financial Crisis. 2008, Harriman House Ltd. Rothbard, Murray N. The Mystery of Banking. 2008, Ludwig Von Mises Institute https://www.rbi.org.in/ https://www.nabard.org/english/mission.aspx http://www.eximbankindia.in/organisation http://www.sidbi.com/twenty_five_years_of_sidbi.php https://www.ifciltd.com/?q=content/what-we-are https://www.idbi.com:8443/idbi-bank-history.asp https://rbi.org.in/scripts/PublicationsView.aspx?id=9457 https://rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=41556 https://www.rbi.org.in/commonperson/English/Scripts/FAQs.aspx?Id=27#:~:text=As%20of%20now %2C%20such%20agreements,as%20banker%20to%20the%20government. https://www.sidbi.in/en/shareholders