Money is anything which is accepted as a medium of exchange, essentially currency in circulation plus bank deposits. Notes and coins, issued by the central bank account only a tiny proportion of the money supply. The rest is bank deposits which are initially created within the banking sector.
The speed at which money stock changes hand over a period of time in an economy is called velocity of money. It is estimated as the ratio of the nominal Gross Domestic Product (GDP) of a country to money supply (measured either by broad money or narrow money). Typically, the numerical value of velocity of money is greater than one, indicating that a unit of money changes hands more than once in a given period. An increase in the velocity of money takes place when nominal GDP rises faster than money supply and vice-versa.
M1 - Narrow Money
The currency in circulation plus demand deposits in the banking system and other deposits with the central bank, is known as narrow money.
M1: Currency with the public + Deposit money of the public (Demand deposits with the banking system + ‘Other’ deposits with the RBI)
Broad money, covers narrow money plus time deposits in the banking system. Expectedly, velocity based on M1 is higher than velocity based on M3, since the stock of M1 is necessarily smaller than M3.
M3: M1+ Time deposits with the banking system = Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Government’s currency liabilities to the public – Net non-monetary liabilities of the banking sector (Other than Time Deposits).
Commercial banks create money. They can lend out a large proportion of deposits placed within them, since it is unlikely that all customers will ask for their money back at once. New net borrowing by households finances the purchase of homes and consumer goods and services. Such borrowing tends to be sensitive to interest rate and consumer confidence. Growth in household credit is generally good when demand is slack but it can be inflationary when demand is buoyant. Excessive borrowing to finance the acquisition of other financial asset such as shares is also worrisome as it help to drive up their prices making consumers feel more wealthy and ready for a bout of inflationary spending.
Companies borrow to finance their operations, investment and takeovers. Corporate borrowing generally slackens when the economy is booming and funds are generate by buoyant sales. On the other hand, there will be more investment activity when companies are more optimistic. A breakdown by industry will reveal trends in various sectors. High borrowing may reflect either optimism and investment or recession and debt.
In general, if a monetary aggregate (M3) is growing too rapidly i.e. faster than its target rate set by the central bank or faster than is consistent with the central bank’s inflation target, this may be an argument for the central bank to raise rates. Slow monetary growth is a sign of weakening economic activity, and may be an argument for lower rates. However, other signals of inflationary pressures will also be taken into account.
Central Bank Policy Tools
The repo rate is the benchmark policy rate. The repo rate is the rate at which the RBI lends money to banks. The lending operation is done through an auction called the Liquidity Adjustment Facility (LAF) auction. This auction is done on a daily basis and banks wanting to borrow funds from the RBI at the repo rate have to bid for funds in the auction. RBI lends successful bidders funds at the repo rate. The LAF is a collateralised lending platform where banks have to pledge government bonds or treasury bills with the RBI for borrowing money. A rise in repo rate increases cost of funds for banks while a fall in repo rate reduces cost of funds for banks.
Rates linked to repo rates are the Reverse Repo rate and the Marginal Standing Facility (MSF). The MSF is an emergency window for funds for banks. The MSF is set at 1% above the repo rate and banks in need of emergency funds borrow from the MSF window by bidding for funds at the MSF rate. Banks pledge government securities or treasury bills to borrow funds under MSF window.
The reverse repo rate is the rate at which RBI borrows money from banks in the LAF auction. Banks with excess liquidity lends funds to RBI by bidding for reverse repo in the LAF auction. RBI gives government bonds or treasury bills as collateral to the banks. The reverse repo rate is set usually at 1% below the repo rate.
Banks have to keep a percentage of their NDTL (Net Demand and Time Liabilities) as CRR with the RBI. RBI sets the CRR rate to reflect its monetary stance. The CRR rate is set higher if RBI wants banks to keep more money as CRR and lower if RBI wants banks to keep less money as CRR. The more money kept as CRR the less money banks have to lend and less money kept as CRR the more money banks have to lend.
SLR is the percentage of net demand and time liability that banks have to invest in government bonds. RBI sets the SLR rate to reflect its monetary stance. The higher the SLR rate the more money the banks should invest in government bonds and the less money they have to lend. The lower the SLR the less money banks should invest in government bonds and the more money they have to lend.
Open Market Operations
RBI buys and sells government bonds directly in the bond market or through bond purchase and sale auctions. RBI buying government bonds adds liquidity into the system while RBI selling government bonds sucks out liquidity from the system. The higher the liquidity the more money banks have to lend and the lower the liquidity the less money banks have to lend.
Market Stabilization Scheme
MSS securities are special government securities and treasury bills that are used to suck out liquidity from the system. RBI sells MSS bonds through auctions to banks and other investors. The money paid for buying the MSS bonds by investors are then held by the RBI in a special account and does not come into the system. The act of issuing MSS securities is an act of sterilization of excess liquidity, when the liquidity is generated by excessive capital flows into the country.