MONEY AND THE FINANCIAL SYSTEM

OVERVIEW Monetary transmission mechanism Modern financial system Money – kinds, functions, significance Supply of money Demand for money Final system equilibrium RBI – concepts, role and functions Fiscal and monetary policy

MONETARY TRANSMISSION MECHANISM Process by which monetary policy undertaken by the central bank interacts with banks and the rest of the economy to determine – Interest rates – Financial conditions – Aggregate demand – Output – Inflation

MODERN FINANCIAL SYSTEM - ROLE Circulatory system that links together goods, services and finance in domestic and international markets Financial system – money market, markets for fixed interest assets like bonds or mortgages, stock markets and foreign exchange markets Financial intermediaries – commercial banks, insurance companies, pension funds, mutual funds, derivative firms

FUNCTIONS OF FINANCIAL SYSTEM Transfer of resources across time, sectors and regions Manages risks for the economy Pools and subdivides funds depending upon the need of the individual saver or investor Performs an important clearing house function

FLOW OF FUNDS

FINANCIAL ASSETS Claims by one party against another party Money and its two components, currency and checking deposits Savings accounts Credit market instruments Common stocks Money market funds and mutual funds Pension funds Financial derivatives

MONEY

Anything that serves as a commonly accepted medium of exchange and a measure of value Barter Commodity money Modern money

KINDS OF MONEY Metallic coins Paper money Bank deposits

FUNCTIONS OF MONEY Money as a medium of exchange Money as a measure of value Money as a store of value Money as a standard of deferred payments

FEATURES OF MONEY General acceptability Easy portability Divisibility Difficult to counterfeit Value guaranteed by the government Legal enforceability as a mode of compensation

SIGNIFICANCE OF MONEY Money eliminates the problems of barter system Money works as the fifth factor of production Money accelerates the pace of production and growth – by making factor payments and sale of products quick and efficient Money is the lifeblood of modern economy Money facilitates consumers’ choice Money market and credit system evolution resulting in efficient system of financial flows to various sectors of the economy

SUPPLY OF MONEY

SOURCES OF MONEY SUPPLY High power money – by RBI and GoI Money creation by commercial banks – Primary and secondary deposits – Cash reserves required by RBI – Deposit multiplier (total addl deposits / total addl cash reserves) – Credit multiplier (total addl credit creation / total addl cash reserves) Non banking financial intermediaries

MEASURES OF MONEY SUPPLY Money supply is a stock variable and measure of money supply refers to the stock of money at a point of time It is a measure of stock of money available to the public as a means of payments and store of value Public means all economic units including households, firms and institutions

RBI MEASURES OF MONEY SUPPLY M 0 ( reserve money) = currency in circulation + bankers’ deposit with RBI + other deposits with RBI M 1 ( narrow money) = currency with the public + demand deposits with banks + other deposits with RBI M 2 = M 1 + time liabilities of saving deposits with banks + Certificate of Deposits issued by banks + term deposits with banks M 3 ( broad money) = currency with the public + demand deposits with banks + time deposits with banks + other deposits with RBI M 3 = M 1 + time deposits with banks

DEMAND FOR MONEY Transaction demand Asset demand

FINAL SYSTEM EQUILIBRIUM Money market equilibrium is reached when aggregate demand for money meets aggregate supply of money At this point the rate of interest is at its equilibrium level If the interest rate moves from this point, disequilibrium occurs and market corrects on its own to restore equilibrium