Lecture 31

In a fractional reserve banking system, banks keep a fraction of deposits as reserves and the rest to make loans. The RBI sets reserve requirements, which are regulations on the minimum amount of reserves that banks must hold against deposits. Banks may hold more than this minimum amount. The reserve ratio \(R\) is the fraction of deposits that banks hold as reserves, which is the total reserves as a percentage of total deposits.

A T-account is a simplified accounting statement that shows a bank’s assets and liabilities (reserves and loans are assets, whereas deposits are liabilities). It is also sometimes called a balance account.

There are three cases we shall analyze:

• No banking system: The public holds all the money in the form of currency. This is the money supply as well.
• 100% reserve banking system: The bank holds all the money in the form of reserves, so \(R\) is 100%. Banks do not affect the size of the money supply in a 100% reserve banking system.
• Fractional reserve banking system: The bank loans out all but \(R\)% of the deposits. The banks create money by loaning it out. The borrower gets a certain amount of money as both an asset and a liability (debt). So, this sort of system creates money, but not wealth.

The money multiplier is the amount of money the banking system generates with each dollar of reserves. It is equal to \(1/R\). If the money a borrower takes is deposited back in another bank, and so on, the total amount of money that arises from one unit is \(1/R\) units.

The control over the money supply is called the monetary policy. In India, it is conducted by a partially independent institution called the Reserve Bank of India (RBI).
The monetary policy is a traditionally bi-annual policy statement through which the RBI targets a key set of indicators to ensure price stability.
At times of recession, the policy involves the adoption of tools to increase the money supply and lower interest rate, thus stimulating the aggregate demand in the economy.
At times of inflation, it seeks to contract aggregate spending by tightening the money supply or raising the rate of return The three tools it uses to do so are:

• Open-Market Operations (OMOs): The purchase and sale of Indian government bonds by the RBI. To increase money supply, they buy bonds, paying with new dollars, which are deposited in banks increasing reserves, which banks use to make loans causing money supply to expand.
  To reduce money supply, they sell government bonds, taking dollars out of circulation and the process works in reserve. Open-market sales of bonds takes rupees out of the hands of the public, thus reducing the quantity of money in circulation.
  These are easy to conduct and are the RBI’s monetary policy tool of choice.