MACROECONOMICS

Monetary Policy

Kunal Dasgupta
RBI maintains status quo on repo and reverse repo rate at
4.00% and 3.35% respectively; policy stance maintained at
‘accommodative’.

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In this topic, we shall discuss

• Model of money supply

• Tools of monetary policy
• Monetary policy in India

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Model of money supply
• The money supply in an economy, M (or M 1), is

M = C + D,

where
• C: currency
• D: demand deposits
• It is the dependence of money supply on demand deposits
that makes the banking system assume a key role in any
economy.

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Definition
Deposits that banks have received but not lent out are called
reserves (R).

To understand how the banking system a↵ects money supply in

an economy, we shall consider three scenarios:

1. No banks
2. 100-percent-reserve banking
3. Fractional-reserve banking

In each scenario, we assume that initial C = |1000.

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No banks

• Without banks,
D = 0.

• Hence,
M = C.

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100-percent-reserve banking

• Let us assume that initially, there are no banks.

• Hence initially,
C = |1000, D = |0,

and
M = |1000.

• Now suppose households deposit the |1000 in Firstbank.

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 Firstbank’s Balance Sheet
Assets Liabilities

R = |1000 D = |1000

• Unlike modern commercial banks, Firstbank does not give

loans.
• Its reserves must cover the entire amount of deposits.

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• After the deposit,

C = |0, D = |1000,

and
M = |1000.

• Under 100-percent-reserve banking, money supply is not

a↵ected by the banking system.

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Fractional-reserve banking

• In this scenario, banks start using their deposits to make

loans (L) to households and firms.
• The main advantage to banks is that they can charge
interest on loans and earn profit.
• Lending is possible because all depositors do not typically
withdraw their deposits at the same time.

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• Suppose banks hold 20 percent of deposits in reserve.

Firstbank’s Balance Sheet

Assets Liabilities

R = |200 D = |1000
L = |800

• After the deposit,

C = |800, D = |1000,

and
M = |1800.

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• Suppose the borrower deposits the |800 in Secondbank.

Secondbank’s Balance Sheet

Assets Liabilities

R = |160 D = |800
L = |640

• After the deposit,

C = |640, D = |1800,

and
M = |2440.

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• Suppose the borrower deposits the |640 in Thirdbank.

Thirdbank’s Balance Sheet

Assets Liabilities

R = |128 D = |640
L = |512

• After the deposit,

C = |512, D = |2440,

and
M = |2952.

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• Suppose the ratio of reserves to deposits is r.
• Then, in general,

M = C0 [1 + (1 r) + (1 r)2 + .....],
1
= C0 ⇥ .
r
where C0 is the initial cash in the hands of the public.
• In this example, C0 = |1000 and r = 0.2
• Hence, M = |5000.

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A model of money supply

Exogenous variables:

• Monetary Base: B = C + R.
• B is controlled directly by the central bank.

• Reserve-deposit ratio: rd = R/D.

• Depends on banks’ policies and regulations.

• Currency-deposit ratio: cd = C/D.

• Depends on households’ preferences and technology.

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• We start with the following two equations:

M = C + D. (1)

and
B = C + R. (2)

• Dividing (1) by (2) and manipulating,

M C/D + 1
= .
B C/D + R/D

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Hence, we have
M = mB,

where
cd + 1
m= ,
cd + rd
is known as the money multiplier.

• Note that as long as rd < 1, m > 1.

• Furthermore, M B = m =) a |1 increase in the monetary
base causes money supply to rise by |m.

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• An increase in cd reduces the money multiplier (only when
rd < 1).
=) For a given B, M falls.
• An increase in rd reduces the money multiplier.
=) For a given B, M falls.

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Application: Bank Panics during the Great Depression

• Many economists believe that a primary cause of the Great

Depression was a sharp reduction in the supply of money.
• Due to a large number of bank failures,
• public confidence in the banking system fell, thereby raising
cd.
• bankers became more cautious, thereby raising rd.
• For a relatively constant B, the money multiplier fell.

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Monetary base and M1 during the Great Depression

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Currency-Deposit and Reserve-Deposit ratios during the Great
Depression

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• By 1933, almost 11,000 of the roughly 25,000 banks had
disappeared in the U.S.
• After becoming President in 1933, Franklin D. Roosevelt
announced a three day bank holiday.
• One of the key developments during his tenure was the
establishment of the Federal Deposit Insurance
Corporation (FDIC).

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Bank capital, leverage, and capital requirements

• In the previous model of the banking system, we had made

a simplifying assumption – banks can be set up costlessly.
• In reality, just like any other business, bank owners require
financial resources to start a bank.
• These resources are called bank capital.

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A more realistic balance sheet:

Assets Liabilities

Reserves |200 Deposits |750

Loans |500 Debt |200
Securities |300 Capital/Equity |50

• The bank can raise money from the owners as well as by

issuing debt to the public.
• The allocation of resources across assets is done by
comparing their net benefits.

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A more realistic balance sheet:

Assets Liabilities

Reserves |200 Deposits |750

Loans |500 Debt |200
Securities |300 Capital/Equity |50

• The use of borrowed money to supplement existing funds

for purposes of investment is called leverage.
• The leverage ratio is the ratio of assets to capital, which, in
this case, is |1000/|50 = 20.

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A more realistic balance sheet:

Assets Liabilities

Reserves |200 Deposits |750

Loans |500 Debt |200
Securities |300 Capital/Equity |50

• Being highly leveraged makes banks much more vulnerable

to economic fluctuations.
• Suppose the value of assets drops by 5%. Then,

capital = assets - liabilities net of capital = 0.

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• When financial intermediaries have a lot of capital, i.e.,
when their leverage is low, they can absorb losses without
going bankrupt.
• But when they have little capital, i.e., when their leverage
is high, even small losses can lead to bankruptcy.
• Furthermore, the higher the leverage, the more likely the
bank is to go bankrupt.

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Example

• Suppose a bank has assets equal to A .....

• ..... and equity equal to x.
• The asset generates a return of r percent.
• r is drawn from some probability distribution with
support [ 1, +1].
• Observe that the bank’s liabilities, net of capital, is A x.

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• The bank defaults if

(1 + r)A (A x) < 0
x
=) r < .
A
• Hence, the probability that the bank defaults is
x
P rob(r < A ).
• What happens to this probability as x becomes smaller?

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• To prevent banks from being highly leveraged, regulators
could ask banks to maintain sufficient capital – a capital
requirement.
• Capital requirement might depend on the type of assets
that banks hold:
• For safe assets such as government bonds, the capital
requirement might be low.
• For risky assets such as mortgage-backed securities, the
capital requirement might be high.

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Debt/Equity for major investment banks in the U.S.

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