Money Market Notes – CA Inter Economics Notes

Money Market Notes – CA Inter Economics Notes is designed strictly as per the latest syllabus and exam pattern.

Money Market Notes – CA Inter ECO Notes

1. Functions of Money:

  • Money is a convenient medium of exchange,
  • Money is an explicitly defined unit of value or ‘common measure of value’ or ‘common denominator of value’,
  • Money serves as a unit or standard of deferred payment.

2. General Characteristics of Money:

  • Generally acceptable,
  • Durable or long-lasting,
  • Effortlessly recognizable,
  • Difficult to counterfeit i.e. not easily reproducible by people,
  • Relatively scarce, but has elasticity of supply,
  • Portable or easily transported,
  • Possessing uniformity; and
  • Divisible into smaller parts.

Money Market Notes – CA Inter Economics Notes

3. The Demand for Money:
If people desire to hold money, we say there is demand for money. Demand for money is actually demand for liquidity and demand to store value.

4. Classical Approach: The Quantity Theory of Money (QTM):

The quantity theory of money, one of the oldest theories in Economics, was 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. 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
V = transactions velocity of circulation
P = average price level (P = MV/T)
T = the total number of transactions.
Fisher’s extended the equation:
MV + M’V’ = PT
Where,
M’ = the total quantity of credit money
V’ = velocity of circulation of credit money

5. The Neo-classical Approach Or The Cambridge Approach:
In the early 1900’s Cambridge Economists Alfred Marshall, A.C. Pigou, D.H. Robertson and John Maynard Keynes put forward a fundamentally different approach to quantity theory, known as neoclassical theory or cash balance approach. The Cambridge version holds that money increases utility in the following two ways:

  • Enabling the possibility of split-up of sale and purchase to two different points, and
  • Being a hedge against uncertainty.

The Cambridge equation:
Md = k PY
Where,
Md = demand for money
Y = real national income
P = average price level
PY = nominal income
k = proportion of nominal income (PY) that people want to hold as cash balances

6. The Keynesian Theory of Demand for Money:
Keynes’ theory of demand for money is known as ‘Liquidity Preference Theory ’. According to Keynes, people hold money (M) in cash for three motives:

  • Transactions motive,
  • Precautionary motive, and
  • Speculative motive.

Money Market Notes – CA Inter Economics Notes

7. Inventory Approach to Transaction Balances:
Baumol(l 952) and Tobin {1956) developed a deterministic theory of transaction demand for money, known as Inventory Theoretic Approach, in which money or Veal cash balance’ was essentially viewed as an inventory held for transaction purposes. Inventory models assume that there are two media for storing value:

  • Money and
  • An interest-bearing alternative financial asset.

There is a fixed cost of making transfers between money and the alternative assets and Liquid financial assets other than money offer a positive return.
Therefore, people hold an optimum combination of bonds and cash balance, i. e., an amount that minimizes the opportunity cost.

8. Friedman’s Restatement of The Quantity Theory:
Milton Friedman (1956) extended Keynes’ speculative money demand within the framework of asset price theory.

  • The demand for money as nothing more than theory of demand for capital assets
  • Demand for money is affected by the same factors as demand for any other asset, namely:
  • Permanent income
  • Relative returns on assets (which incorporate risk).

Friedman identifies the following four determinants of the demand for money:

  • is a function of total wealth,
  • is positively related to the price level, P,
  • rises if the opportunity costs of money holdings decline,
  • is influenced by inflation.

9. The demand for money as behaviour toward risk (Tobin’s Risk-Aversion Approach):
In his classic article, ‘Liquidity Preference as Behaviour towards Risk’(1958), Tobin established that the theory of risk-avoiding behaviour of individuals provided the foundation for:

  • The liquidity preference and
  • For a negative relationship between the demand for money and the interest rate.

According to Tobin, the optimal portfolio structure is determined by:

  • The risk/reward characteristics of different assets,
  • The taste of the individual in maximizing his utility consistent with the existing opportunities.
    Demand for money as a store of wealth will decline with an increase in the interest rate.

10. Measurement of Money Supply:
From April 1977, the RBI has been publishing data on four alternative measures of money supply denoted by Ml, M2, M3 and M4 besides the reserve money:
M1 = Currency notes and coins with the people + demand deposits
of banks (Current and Saving deposit accounts) + other deposits with the RBI
M2 = M1 + savings deposits with post office savings banks
M3 = M1 + net time deposits with the banking system
M4 = M3 + total deposits with the Post Office Savings Organization
(excluding National Savings Certificates)

Following the recommendations of the Working Group on Money (1998), the RBI has started publishing a set of four new monetary aggregates:

Reserve Money = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI
= Net RBI credit to the Government + RBI credit to the Commercial sector + RBI’s Claims on banks+RBI’s net

Foreign assets + Government’s Currency liabilities to the public-RBI’s net non monetary Liabilities
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

‘Liquidity’ aggregates in addition to the monetary aggregates:
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 FIs + Certificates of deposit issued by FIs
L3 = L2 + Public deposits of non-banking financial companies

11. Money Multiplier:
Money Multiplier (m) = Money supply ÷ Monetary base

12. 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:

  • The stock of high-powered money (H)
  • The ratio of reserves to deposites, e = (ER/D) and
  • The ratio of currency to depoists, c = (C/D)

To summarise the money multiplier approach, the size of the money multiplier is determined by the required reserve ratio (r) at the central bank, the excess reserve ratio (c) of commercial banks and the currency ratio (c) of the public. The lower these ratios are, the larger the money multiplier is.

13. The Credit Multiplier: Credit Multiplier = 1 ÷ Required Reserve Ratio

14. Monetary Policy Defined:
Monetary policy is essentially a programme of action undertaken by the monetary authorities, normally the central bank, to control and regulate the demand for and supply of money with the public and the flow of credit with a view to achieving predetermined macroeconomic goals.

15. The Monetary Policy Framework:

  • The objectives of monetary policy,
  • The analytics of monetary policy, and
  • The operating procedure.

Money Market Notes – CA Inter Economics Notes

16. The Objectives of Monetary Policy:
The objectives of monetary policy generally coincide with the overall objectives of economic policy. In developing countries:

  • Maintenance the economic growth,
  • Ensuring an adequate flow of credit,
  • Sustaining – a moderate structure of interest, and
  • Creation of an efficient market for government securities.

17. Analytics of Monetary Policy:
The process or channels through which the change of monetary aggregates affects the level of production and prices etc. There are mainly four different mechanisms:

  • The interest rate channel,
  • The exchange rate channel,
  • The quantum channel (relating to money supply and credit), and
  • The asset price channel ie. via equity and real estate prices.

18. Operating Procedures and Instruments:
The operating framework relates to all aspects of implementation of monetary policy. It primarily involves three major aspects, namely,

  • Choosing the operating target,
  • Choosing the intermediate target, and
  • Choosing the policy instruments.

The operating target refers to the variable (e.g. inflation) that monetary policy can influence with its actions.
The intermediate target (e.g. economic stability) is a variable which the central bank can hope to influence to a reasonable degree through the operating target and which displays a predictable and stable relationship with the goal variables.

The monetary policy instruments are the various tools that a central bank can use to influence money market and credit conditions and pursue its monetary policy objectives.

19. Cash Reserve Ratio (CRR):
Cash Reserve Ratio (CRR) refers to the fraction of the total net demand and time liabilities (NDTL) of a scheduled commercial bank in India which it should maintain as cash deposit with the Reserve Bank.

20. Statutory Liquidity Ratio (SLR):
As per the Banking Regulations Act, 1949, all scheduled commercial banks in India are required to maintain a stipulated percentage of their total Demand and Time Liabilities (DTL)/Net DTL (NDTL) in one of the following forms:

  • Cash
  • Gold, or
  • Investments in unencumbered Instruments

21. Liquidity Adjustment Facility (LAF):
LAF is a facility extended by the Reserve Bank of India to the scheduled com-mercial banks (excluding RRBs) and primary dealers to avail of liquidity in case of requirement on an overnight basis against the collateral of government securities including State Government securities.

22. Marginal Standing Facility (MSF):
The Marginal Standing Facility (MSF) announced by the Reserve Bank of India “
(RBI) in its Monetary Policy, 2011-12 refers to the facility under which scheduled commercial banks can borrow additional amount of overnight money from the central bank over and above what is available to them through the LAF window by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest.

23. Market Stabilisation Scheme (MSS):
This instrument for monetary management was introduced in 2004 following – a MoU between the Reserve Bank of India (RBI) and the Government of India (GOI) with the primary aim of aiding the sterilization operations of the RBI. Under this scheme, the Government of India borrows from the RBI and issues treasury-bills/dated securities for absorbing excess liquidity from the market arising from large capital inflows.

24. The Monetary Policy Framework Agreement:
Agreement reached between the Government of India and the RBI on the maximum tolerable inflation rate that the RBI should target to achieve price stability. The amended RBI Act (2016) provides for a statutory basis.

  • The inflation target is to be set, once in every five years
  • 4 percent CPI inflation as the target for August 5, 2016 to March 31, 2021
  • Upper tolerance limit of 6 percent and the lower tolerance limit of 2 percent
  • Publish a Monetary Policy Report every six months,
  • The following factors are notified by the CG:
  • The average inflation is more than the upper tolerance level for any three consecutive quarters; or
  • The average inflation is less than the lower tolerance level for any three consecutive quarters.

Money Market Notes – CA Inter Economics Notes

25. The Monetary Policy Committee (MPC):
An important landmark in India’s monetary history is the constitution of an empowered six-member Monetary Policy Committee (MPC) in September, 2016 consisting of the RBI Governor (Chairperson), the RBI Deputy Governor in charge of monetary policy, one official nominated by the RBI Board and the remaining three Central Government nominees representing the Government of India who are persons of ability, integrity and standing, having knowledge and experience in the held of Economics or banking or finance or monetary policy.

26. Repurchase Options or in short ‘Repo’: is defined as ‘an instrument for borrowing funds by selling securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed’.

27. Reverse Repo: is defined as an instrument for lending funds by purchasing securities with an agreement to resell the securities on a mutually agreed future date at an agreed price which includes interest for the funds lent.

28. Bank Rate: Under Section 49 of the Reserve Bank of India Act, 1934, the Bank Rate has been defined as ‘the standard rate at which the Reserve Bank is prepared to buy or rediscount bills of exchange or other commercial paper eligible for purchase under the Act’. The bank rate once used to be the policy rate in India i.e. the key interest rate based on which all other short term interest rates moved.

29. Open Market Operations: Open Market Operations (OMO) is a general term used for market operations conducted by the Reserve Bank of India by way of sale/purchase of Government securities to/from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis.

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