The Economics of Money supply

Money supply is one of the most important topics in economics. Monetarists believe half of world problems can be resolved by having an efficient monetary policy.

So let me try making the whole thing easier. What do you think is money supply? How can we increase or decrease it? What are the various interest rates we need to be aware of viz Cash Reserve Ratio, Statutory liquidity ratio, Repo rate and Reverse Repo rate?

Let us relate money supply to the salary we receive on a monthly basis.

Case 1: The salary is your monthly dose of money supply. When you have an increment you are flush with more money. When you have a decrement you have less money to spend.

Corollary 1: When RBI (central bank) starts printing more money the money supply in the economy increases. When it stops printing and starts to purchase the same from the market, the money supply decreases.

Case 2: Your bank tells you to have a Minimum Balance in your salary account. This entails lesser money at the hands of the individual as one has to necessarily maintain this minimum balance to avoid penalty. If the minimum balance amount increases an individual would have lesser money spend.

Corollary 2: RBI asks all commercial banks to hold a certain portion of their deposits in the form of cash. This is called “Cash reserve ratio (CRR)”. If CRR is hiked the banks would have lesser money to lend.

Case 3: The bank wealth management team suggests that you manage your wealth by investing 25% of salary in Gold, Equity funds and a life insurance policy on a monthly basis. This further reduces the cash available for spending. If the ratio increases to 50% you would be left with a niggling amount to spend.

Corollary 3: RBI asks all commercial banks to hold a certain portion of their net demand and time liabilities (i.e. savings and term deposits) in the form of cash, gold and Government securities. This is called the “Statutory liquidity ratio (SLR)”. If the SLR gets hiked, the banks would have to hold further amount in the form of cash, gold or G-secs.

Case 4: On one particular month you realize you have a liquidity crunch (No cash). You approach the bank for short term (30 day) loan. The bank asks you to deposit gold (or LIC policy) as collateral and lends you the money at a rate of interest of 6%. You repay the money after 30 days and the bank gives you back your block of gold. This can be thought of a repurchase agreement, where you offer to repurchase the block of gold from the bank after 30 days by paying the principal and interest amount on the loan. If the bank increases the interest rate, your interest expenses would increase resulting in lower cash to spend.

Corollary 4: When banks have a liquidity crunch they go to RBI and ask for money. In turn they offer G-secs as collateral to RBI. The RBI offers to pay lend them money by charging interest on the invested amount. This interest is known a Repo rate. (Repo doesn’t mean repository but repurchase agreement as discussed in case 4). When repo increases the banks pay higher interest to RBI hence they increase their lending rates. When lending rates increase there is lower incentive for people to borrow. Hence money supply decreases in the economy.

Case 5: On another month you realize you have surplus cash. You approach the bank for 30 day term deposit. The bank tells you it would pay 5% interest on the deposit. If the bank increases the interest rate you would be more inclined to save money than spend it. Thus reducing your money-spend supply.

Corollary 5: When banks have extra cash they park the surplus with RBI. The RBI takes the money and assures them an interest. This interest is known a Reverse Repo rate. However the slight difference between the case and corollary is that RBI gives off G-sec against the money deposited by banks with an agreement to buy them back in future. Our bank offers us no collateral in case it defaults on its commitment. When reverse repo rate increases banks have a disincentive to lend as RBI offers them a higher rate at almost zero risk. Banks would therefore demand for higher returns on their investment thereby increasing interest rate and thus reducing money supply.