Model Answer
0 min readIntroduction
High-powered money, also known as the monetary base, is the total amount of currency in circulation plus commercial banks’ reserves held at the central bank. It forms the foundation upon which the entire money supply is built. In India, the Reserve Bank of India (RBI) controls this base through various monetary policy instruments. Recent shifts in RBI’s monetary policy, particularly the adoption of a flexible inflation targeting framework since 2016, have significantly impacted the management of high-powered money and its subsequent effects on the broader economy. Understanding this relationship is vital for comprehending the effectiveness of monetary policy in achieving macroeconomic stability.
What is High-Powered Money?
High-powered money (HPM) consists of currency in circulation (CIC) held by the public and commercial banks’ reserves with the central bank (RBI). It is represented by the formula: HPM = CIC + Commercial Banks’ Reserves. Commercial banks’ reserves include cash reserves held with the RBI (CRR - Cash Reserve Ratio) and deposits held with the RBI (excess reserves). HPM is considered ‘high-powered’ because it has the potential to create multiple deposits through the process of credit creation by commercial banks.
How Monetary Policy Affects High-Powered Money
The RBI utilizes several tools to influence HPM:
- Open Market Operations (OMO): When the RBI purchases government securities from commercial banks, it injects money into the banking system, increasing both CIC and bank reserves, thereby expanding HPM. Conversely, selling securities reduces HPM.
- Reserve Requirements (CRR & SLR): Increasing the Cash Reserve Ratio (CRR) – the percentage of deposits banks must hold with the RBI – reduces the amount of money banks have available for lending, decreasing HPM. Similarly, increasing the Statutory Liquidity Ratio (SLR) – the percentage of deposits banks must hold in liquid assets – also reduces lending capacity and HPM.
- Repo and Reverse Repo Rates: Lowering the repo rate (the rate at which the RBI lends money to commercial banks) encourages banks to borrow more, increasing reserves and HPM. Raising the repo rate has the opposite effect. Reverse repo rate influences liquidity absorption.
- Liquidity Adjustment Facility (LAF): The LAF, comprising repo and reverse repo auctions, is the primary tool for daily liquidity management, directly impacting bank reserves and HPM.
The Money Multiplier
The money multiplier (k) determines the maximum amount of commercial bank money that can be created from each unit of high-powered money. It is calculated as: k = (1 + CURR) / (CRR + RRR), where CURR is the currency ratio (the proportion of money held by the public as cash) and RRR is the required reserve ratio.
Changes in HPM directly affect the money supply (M) through the money multiplier: M = k * HPM.
Impact of Monetary Policy on Money Multiplier:
- If the RBI increases HPM through OMO, and the money multiplier remains constant, the money supply will increase proportionally.
- However, changes in the CRR directly affect the money multiplier. An increase in CRR reduces the multiplier, limiting the expansionary effect of an increase in HPM.
- Changes in public preference for holding cash (CURR) also influence the multiplier. If people prefer to hold more cash, the multiplier decreases.
Example: Suppose HPM is ₹2000 crore and the money multiplier is 5. The money supply will be ₹10,000 crore. If the RBI increases HPM to ₹2200 crore, and the multiplier remains at 5, the money supply will increase to ₹11,000 crore.
| Monetary Policy Tool | Impact on HPM | Impact on Money Multiplier |
|---|---|---|
| Open Market Purchase | Increases | Generally unchanged (unless affects public preference for cash) |
| Increase in CRR | Decreases | Decreases |
| Decrease in Repo Rate | Increases | Generally unchanged |
Conclusion
In conclusion, high-powered money serves as the base for the money supply, and the RBI’s monetary policy tools are crucial in controlling it. Changes in these tools directly impact HPM, which, in turn, influences the money supply through the money multiplier. However, the effectiveness of monetary policy is also contingent on factors like the currency ratio and public confidence in the banking system. A nuanced understanding of these interactions is essential for policymakers to effectively manage inflation and promote economic growth.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.