UPSC CSEMAINSGS 3ECONOMICPillar 1A2) MONEY’S DEMAND, SUPPLY & CREATION

A2) MONEY’S DEMAND, SUPPLY & CREATION

📑 TABLE OF CONTENTS

  • 11. Money’s Demand, Supply & Creation
    • 11.11 Demand of Money: Liquidity Preference Theory (Keynes)
    • 11.12 Deposit Types (Time vs Demand, Green, Bulk, Inoperative)
    • 11.12.6 Full Reserve vs Fractional Reserve Banking
    • 11.13 Measures of Money Supply (M0, M1, M2, M3, M4)
    • 11.14 Money Multiplier (MM): Formulas, Leakages, and Trends
    • 11.15 M0: Reserve Money Formula & Factors
    • 11.16 Creation of Money: RBI Balance Sheet (Assets vs Liabilities)
    • 11.17 Money Supply & FRBM Act (Monetization of Deficit)
    • 11.17.4 Velocity of Money Circulation
  • 12. Monetary Policy (मौद्रिक नीति)
    • 12.11 Quantitative Tools: CRR & SLR (Statutory Requirements)
    • 12.13 NIM, Liquidity Overhang, and ₹2000 Withdrawal
    • 12.14 Incremental CRR (I-CRR)
    • 12.15 LAF: Repo, Reverse Repo, VRRR
    • 12.17 Special Windows (TLTRO, SLTRO)
    • 12.17.4 MSF, Bank Rate, and SDF (Standing Deposit Facility)
    • 12.17.8 Policy Corridor / LAF Corridor
    • 12.18 Open Market Operations (OMO) & Operation Twist
    • 12.19 Bond Yield Logic & Retail Direct Scheme (RDG)
    • 12.20 G-SAP (G-Sec Acquisition Programme)
    • 12.21 Qualitative Tools: Moral Suasion, LTV, Credit Rationing
    • 12.22 Priority Sector Lending (PSL): Targets, Reforms, Shortfalls
    • 12.24 Monetary Policy Committee (MPC) & Inflation Targeting (FIT)
    • 12.29 Banks’ Lending Rates: BPLR ➔ Base Rate ➔ MCLR ➔ External Benchmark
    • 12.31 Limitations: Supply-side issues, Structural issues, Lazy Banking
    • 12.31.1 QE & Fed Tapering Impact
    • 12.32 Soft Landing, Cantillon Effect, and Liquidity Trap
  • ❓ COMPREHENSIVE PYQ SECTION

11. 💸 MONEY’S DEMAND, SUPPLY & CREATION

11.11 Liquidity Preference Theory (तरलता अधिमान)

John Maynard Keynes (1936) identified 3 motives for holding liquid cash:

  1. Transaction Motive: For daily exchange (milk, veggies). 🥦
  2. Precautionary Motive: For unforeseen emergencies (medical, trips). 🚑
  3. Speculative Motive: Holding cash to buy assets (gold/land) when prices fall. 📉

Interest Rate Rule: Cash demand varies inversely with interest rates. If bank rates are high, people invest in banks instead of holding cash.

11.12 Deposit Types & Rules 🏦

  • Time Liabilities (FDRD): Fixed/Recurring deposits. Bank can penalize early withdrawal.
  • Green Deposits (2023): Fixed deposits used for environment-friendly projects (Renewable energy, waste management). Forbidden: Nuclear power, tobacco, fossil fuels. 🌿
  • Bulk Deposits (2024): Fixed deposits of ₹3 crore or higher (previously ₹2 cr).
  • Inoperative Account: No transaction for 2 years.
  • Unclaimed Deposits: Not operated for 10 years. Transferred to RBI's DEA Fund.
  • UDGAM Portal: RBI's portal to search unclaimed deposits using Aadhaar/PAN. 🔍

11.12.6 Full vs Fractional Reserve Banking

  • Full Reserve: Banks can't lend from Demand Deposits. High safety, 0% interest to depositors. 🛑
  • Fractional Reserve (India): Banks keep a fraction (CRR/SLR) and lend the rest. Prone to Bank Runs. 🏃‍♂️

11.13 Measures of Money Supply (M0-M4) 📊

MeasureCurrency with Public (CU)Demand Depo (CASA)Time Depo (FDRD)Post Office DepoLiquidityQty
M1 (Narrow)✅✅❌❌♠️♠️♠️♠️ (Max)♠️ (Min)
M2✅✅❌✅ (SA)♠️♠️♠️♠️♠️
M3 (Broad)✅✅✅❌♠️♠️♠️♠️♠️
M4✅✅✅✅ (All)♠️ (Min)♠️♠️♠️♠️ (Max)
  • M3 = Aggregate Monetary Resources (RBI's focus tool).
  • Formula logic: M3=M1+Time deposits with banksM3 = M1 + Time\ deposits\ with\ banks.

11.13.1 Duration of Interbank Loans ⏰

  • Call Money: Borrowed for 1 day ("Overnight").
  • Notice Money: 2 to 14 days.
  • Term Money: 15 days to less than 1 year.

11.14 Money Multiplier (MM) ⛵

  • Formula: MM=M3/M0MM = M3 / M0.
  • Concept: Amount of M3 generated with each rupee of M0.
  • Inverse Relation: MM=1/CRRMM = 1 / CRR. If CRR is 4%, theoretical MM is 25x.
  • Leakages: High CRR and public holding cash (instead of depositing) reduce MM. 🚰
  • 2023 Trends: MM increased due to ₹2000 withdrawal (more deposits) and HDFC merger. MM is currently >5x.

11.15 Reserve Money (M0 / High Powered Money) 🌋

Formula: Currency in Circulation + Bankers' Deposits with RBI + 'Other' Deposits with RBI.

  • Factors: M0 increases if CRR increases or Net Foreign Assets (NFA) increase.

11.16 creation of Money & RBI Balance Sheet ⚖️

RBI Issue Department Assets:

  1. Rupee Coins/₹1 Notes (RBI buys from Govt).
  2. Gold Coins (Min ₹200cr) & Bullion (Min ₹115cr).
  3. Foreign Securities (incl. IMF).
  4. Govt Securities (G-Secs).

Liabilities (M0): Bank notes in circulation + Bankers' Deposits. FAQ: ₹1 notes/coins are Govt liabilities, but RBI circulates them as an agent.

11.17 FRBM Act & Money Supply 📜

  • FRBM Act 2003: Bans RBI from buying G-Sec in the Primary Market (direct lending to Govt) except during war, disaster, or agri-crisis.
  • Monetization of Deficit: RBI printing money to lend to Govt (Currently restricted).
  • Velocity of Money: Average number of times a note changes hands. Higher in poor populations and booming economies. 💸🔁

12. 🦁 MONETARY POLICY (मौद्रिक नीति)

12.11 Quantitative Tools (Volume Control)

  1. CRR (Cash Reserve Ratio): Banks park % of NDTL in Cash with RBI. 0% Interest. Currently 4.5%.
  2. SLR (Statutory Liquidity Ratio): Banks keep % of NDTL with themselves in liquid assets (Gold, Cash, G-Sec). Max limit 40%. Currently 18%.
  • Penalty: If not maintained fortnightly, penalty linked to Bank Rate.

12.13 NIM & Overhang 📉

  • NIM (Net Interest Margin): Loan Int% - Deposit Int%. Healthy range: 3-4%. >5% is risky for stability.
  • Liquidity Overhang: Money Supply >> Loan Demand. Happens during Demonetization or QE.

12.14 Incremental CRR (I-CRR)

Temporary measure (Aug-Oct 2023) to absorb excess liquidity from ₹2000 note withdrawal. 10% extra CRR was applied.

12.15-12.17 LAF & Policy Rates 🚥

  • Repo Rate: RBI lends to banks (collateral required). This is the Policy Rate.
  • Reverse Repo: Banks park money with RBI. Currently 3.35%.
  • MSF (Marginal Standing Facility): Emergency loan (Overnight); banks can use SLR-quota G-Secs. Rate = Repo+0.25%Repo + 0.25\%.
  • SDF (Standing Deposit Facility): Sucks liquidity without collateral. It is the new Floor of the corridor. Rate = Repo−0.25%Repo - 0.25\%.
  • Bank Rate: For rediscounting bills. Now used to decide penalties on banks.

Policy Corridor Width: MSF (Ceiling)−SDF (Floor)=0.50%MSF\ (Ceiling) - SDF\ (Floor) = 0.50\%.

12.18 Open Market Operations (OMO) 🌪️

  • Outright OMO: RBI buys/sells G-Secs without repurchase promise.
  • Operation Twist (2019): Simultaneously buying Long-term G-Secs and selling Short-term ones to lower long-term yields and make corporate loans cheaper. 🥨
  • Bond Yield Logic: Bond Yield∝1/PriceBond\ Yield \propto 1/Price. If demand for bonds ↑, Price ↑, Yield ↓. 📉

12.21 Qualitative Tools (Selective Control) 🎯

  1. Moral Suasion: Persuasion via conferences/letters. 🎤
  2. Direct Action: Punishment for non-compliance (Clawback of bonuses).
  3. LTV (Loan to Value): Capping loans against collateral (e.g., Gold loan LTV 90%).
  4. Selective Credit Control: Credit rationing or ceilings on non-food loans.

12.22 Priority Sector Lending (PSL) 🚜

Banks must give 40% of loans to priority sectors:

  • Agriculture: 18% (includes 10% for Small/Marginal farmers).
  • Weaker Sections: 12% (SC/ST, women, beneficiaries of NRLM).
  • Micro Enterprises: 7.5%.
  • Shortfalls: Money goes to RIDF (NABARD) or UIDF (NHB - specifically for Tier 2/3 cities). 🏦

12.24 Monetary Policy Committee (MPC) ⚖️

  • Structure: 6 members (3 RBI, 3 Govt). RBI Governor is Ex-officio Chairman.
  • Meeting: Min 4 times a year. Quorum = 4.
  • Target: Flexible Inflation Targeting (FIT) – Keep CPI within 4% (+/- 2%). 🎯
  • Casting Vote: Governor has a second/deciding vote in case of a tie.

12.30 Banks’ Lending Rate Evolution 🕙

  1. 1969: Administered rates (Govt decided).
  2. 2003: BPLR (Benchmark Prime Lending Rate) - Lacked transparency.
  3. 2010: Base Rate - Banks had too much discretion.
  4. 2016: MCLR (Marginal Cost based) - Transmission was slow.
  5. 2019-Present: External Benchmark (EBLR). Tied to Repo or T-Bill yields. Mandatory update every 3 months. 📊

12.31-12.32 Policy Limitations & failures

  • Supply Side: RBI can't control El-Nino or Global Oil shocks. 🛢️
  • Soft Landing: Attempt to reduce inflation without causing a recession. ✈️
  • Cantillon Effect: Newly printed money benefits the rich first (who get cheap loans to buy assets). 🏰
  • Liquidity Trap: Low interest rates don't boost spending because people prefer holding cash (Speculative demand is infinite). 🕳️

❓ PREVIOUS YEAR QUESTIONS (PYQs) - A2 PILLAR

Q1. If you withdraw Rs. 1,00,000 in cash from your Demand Deposit Account, the immediate effect on aggregate money supply will be: (Pre-2020) (a) To reduce it by ₹ 1,00,000 (b) To increase it by ₹ 1,00,000 (c) To increase it by more than ₹ 1,00,000 (d) To leave it unchanged Ans: (d)

Q2. Money Multiplier in an economy increases with: (Pre-2019/2021) A) Increase in the cash reserve ratio B) Increase in the banking habit of the population C) Increase in the statutory liquidity ratio D) Increase in the population of the country Ans: (B)

Q3. Which of the following are included in Narrow Money? (CDS-2023-II)

  1. Currency with public 2. Demand deposits 3. 'Other' deposits with RBI 4. Banker's deposits with RBI (a) 1, 2 and 4 (b) 1 and 2 only (c) 1, 2 and 3 (d) 3 and 4 only Ans: (c)

Q4. India Government Bond Yields are influenced by: (Pre-2021)

  1. Actions of US Federal Reserve 2. Actions of RBI 3. Inflation and short-term interest rates (a) 1 and 2 Only (b) 2 Only (c) 3 Only (d) 1, 2 and 3 Ans: (d)

Q5. Regarding instruments of monetary policy: (CDS-24-i)

  1. Standing deposit facility (SDF) was introduced in April 2022.
  2. SDF replaced fixed reverse repo rate as the floor of the LAF corridor. (a) 1 only (b) 2 only (c) Both 1 and 2 (d) Neither 1 nor 2 Ans: (c)

Q6. If RBI adopts expansionist monetary policy, which would it NOT do? (Pre-2020)

  1. Cut SLR 2. Increase MSF Rate 3. Cut Bank Rate and Repo Rate (a) 1 and 2 only (b) 2 only (c) 1 and 3 only (d) 1, 2 and 3 Ans: (b)

Q7. Priority Sector Lending by banks in India constitutes loans to: (Pre-2013) (a) Agriculture (b) Micro and Small Enterprises (c) Weaker Sections (d) All of the above Ans: (d)

Q8. An increase in the Bank Rate generally indicates that: (Pre-2013) (a) Market rate of interest likely to fall (b) Central Bank no longer making loans (c) Central Bank is following easy money policy (d) Central Bank is following tight money policy Ans: (d)

END OF PILLAR A2 NOTES. ✍️🇮🇳📖

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