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How Money CET INTO Economy

Money is canalized into the economy by the central bank by means of (1) bankers deposits, and (2) currency. Before we explore the process by which money is channeled it is important for us to understand the concept of ‘High-powered money’. High-powered money is also known as the cash-base or the monetary base.

High-powered money is the monetary magnitude that is under the direct control of the central bank. It comprises as follows:

(i)    Currency held by the public and the banks,
(ii)    Cash reserves of the banker with central bank,
(iii)    Other deposits with the control bank.

This constitutes the monetary base. It is referred to as high-powered money because it is the basis on which a much bigger stock of monetary assets is built (including the biggest comments of money stock, bank deposits).

The central bank gets high-powered money into the economy simply by buying government securities. it pays for these securities with newly issued high-powered money.

1.    Bankers ‘deposits. The process can be illustrated as follows:

Let us begin with a situation in which there are initially no net transactions between the Reserve Bank of India (RBI) and the rest of the economy.

The bank how buys Rs. 1 core worth of securities form an agent in the private sector. The seller receives a cheque for Rs. 1 crore from the RBI. The cheque is credited to the recipient’s bank account at, say, State Bank of India (SBI). SBI’s deposits rise by Rs. 1 crore, but at the same time SBI receives an increase of Rs. 1 core in its deposits at the RBI, which is an example of what are called bankers deposits.

This increase in its bankers ‘deposits arises when the SBI clears the cheque drawn on the RBI.

Bankers’ reserves constitute reserves against which the commercial banks can create new deposits (Further explained in chapter 13 below). Increase in bankers’ reserves helps to expand the monetary wage of the RBI.

When the RBI sells the securities, the bankers, deposits with the RBI fall. A member of the public then writes a cheque drawn oon say, Bank of India, payable to the RBI, and Bank of India transfers bankers’ deposits to the RBI of an equivalent amount. The monetary base falls.

This is how the central banks create or destroy high-powered money.

2.    Currency. The division of high-powered money between bankers’ deposits and currency is determined by the demand for currency on the general public. If general public choose to increase their currency holdings, relative to bank deposits, they simply go to their bank and withdraw deposits in cash. The bank (if it did not have enough cash with itself) would go to the RBI, and withdraw some bankers’ deposits in cash from the RBI. The RBI will print new currency to meet this increased need for cash. Currency is made available demand to the economy in this way.

Technically, the arrangement is as follows: The RBI maintains two departments: issue Department and Banking Department. The only function of the Issue Department is to Issue curacy. It does this in exchange for purchase of securities,  normally though a transaction with the Banking Department. The Banking Department acts as a banker to the government and also holds deposits from the banker. When commercial banks withdraw bankers’ deposits in cash, the Banking Department would replenish its own stock of cash by selling securities to the Issue Department. The Issue Department prints the new currency.

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