DEMAND AND SUPPLY OF MONEY.

INDIAN MONETARY POLICYQUALITATIVE AND QUANTITATIVE MEASURES

LIST OF CONTENTS

1. 2. 3. 4. 5. 6. 7.

Abstract Monetary policy Money supply Empirical measures Qualitative measures of monetary policy. Quantitative measures of monetary policy. Conclusion.

ABSTRACT

In this topic Indian monetary policy has been discussed along with demand and supply of money. Also the various

qualitative and quantitative measures have been discussed so as to understand how the flow of money is controlled by the government.

MONETARY POLICY
Monetary policy rests on the relationship between the rates of interest in an economy, that is, the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money

supply and thus influence the interest rate (to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size of the money supply or increases it only slowly, or if it raises the interest rate. An expansionary policy increases the size of the money supply more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation. There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of contracting the money supply; and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately. Within almost all modern nations, special institutions (such as the Federal Reserve System in the United States, the Bank of England, theEuropean Central Bank, the People's Bank of China, and the Bank of Japan) exist which have the task of executing the monetary policy and often independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system. The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation. . The other primary means of conducting monetary policy include: (i) Discount window lending (lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market). Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). It is important for policymakers to make credible announcements. If private agents (consumers and firms) believe that policymakers are committed to lowering inflation, they will anticipate future prices to be lower than otherwise (how those expectations are formed is an entirely different matter; compare for instance rational expectations with adaptive expectations). If an employee expects prices to be high in the future, he or she will draw up a wage contract with a high wage to match these prices. Hence, the expectation of lower wages is reflected in wage-setting behavior between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is no demand pull inflation because employees are receiving a smaller wage and there is no cost push inflation because employers are paying out less in wages. To achieve this low level of inflation, policymakers must have credible announcements; that is, private agents must believe that these announcements will reflect actual future policy. If an announcement about low-level inflation targets is made but not believed by private agents, wage-setting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible, policy will not have the desired effect. If policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy (where themarginal benefit of increasing economic output outweighs the marginal cost of inflation); however, assuming private agents have rational expectations, they know that policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation. Consequently, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior);so, there is higher inflation (without the benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail.

Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets (but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body. Central banks can be given incentives to meet targets (for example, larger budgets, a wage bonus for the head of the bank) to increase their reputation and signal a strong commitment to a policy goal. Reputation is an important element in monetary policy implementation. But the idea of reputation should not be confused with commitment. While a central bank might have a favorable reputation due to good performance in conducting monetary policy, the same central bank might not have chosen any particular form of commitment (such as targeting a certain range for inflation). Reputation plays a crucial role in determining how much markets would believe the announcement of a particular commitment to a policy goal but both concepts should not be assimilated. Also, note that under rational expectations, it is not necessary for the policymaker to have established its reputation through past policy actions; as an example, the reputation of the head of the central bank might be derived entirely from his or her ideology, professional background, public statements, etc. In fact it has been argued that to prevent some pathologies related to the time inconsistency of monetary policy implementation (in particular excessive inflation), the head of a central bank should have a larger distaste for inflation than the rest of the economy on average. Hence the reputation of a particular central bank is not necessary tied to past performance, but rather to particular institutional arrangements that the markets can use to form inflation expectations. Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning of credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is believed to be the most beneficial. For example, capability to serve the public interest is one definition of credibility often associated with central banks. The reliability with which a central bank keeps its promises is also a common definition. While everyone most likely agrees a central bank should not lie to the public, wide disagreement exists on how a central bank can best serve the public interest. Therefore, lack of definition can lead people to believe they are supporting one particular policy of credibility when they are really supporting another.

Types of monetary policies:

In practice, to implement any type of monetary policy the main tool used is modifying the amount of base money in circulation. The monetary authority does this by buying or selling financial assets (usually government obligations). These open market operations change either

the amount of money or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve banking amplifies the effects of these actions. Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate. The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy: Inflation Targeting Price Targeting Monetary Aggregates Fixed Rate

Target Market Variable:

Long Term Objective:

Interest rate on overnight A given rate of change in the CPI debt

Level Interest rate on overnight A specific CPI number debt The growth in money supply A given rate of change in the CPI Exchange The spot currency price of the

The spot price of the currency Low inflation as measured by the gold price Usually unemployment + CPI change

Gold Standard Mixed Policy

The spot price of gold Usually interest rates

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking exactly the same variables (such as a harmonized consumer price index). Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range. The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally theinterbank rate at which banks lend to each other

overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar. The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee. Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called theTaylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylorof Stanford University.

Monetary aggregates
In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman. This approach is also sometimes called monetarism. While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.

History of monetary field:

Monetary policy is associated with interest rates and availabilility of credit. Instruments of monetary policy have included short-term interest rates and bank reserves through the monetary base. For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seigniorage, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price. Paper money called "jiaozi" originated from promissory notes in 7th century China. Jiaozi did not replace metallic currency, and were used alongside the copper coins. The

successive Yuan Dynasty was the first government to use paper currency as the predominant circulating medium. In the later course of the dynasty, facing massive shortages of specie to fund war and their rule in China, they began printing paper money without restrictions, resulting in hyperinflation. With the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established. The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow bandwith other gold-backed currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates. During the 1870-1920 period, the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913. By this point the role of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal revolution in economics, which demonstrated how people would change a decision based on a change in the economic trade-offs. Monetarist economists long contended that the money-supply growth could affect the macroeconomy. These included Milton Friedman who early in his career advocated that government budget deficits during recessions be financed in equal amount by money creation to help to stimulate aggregate demand for output. Later he advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable output growth. However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was found to be impractical, because of the highly unstable relationship between monetary aggregates and other macroeconomic variables. Even Milton Friedman acknowledged that money supply targeting was less successful than he had hoped, in an interview with the Financial Times on June 7, 2003. Therefore, monetary decisions today take into account a wider range of factors, such as:

short term interest rates; long term interest rates; velocity of money through the economy;

exchange rates; credit quality; bonds and equities (corporate ownership and debt); government versus private sector spending/savings; international capital flows of money on large scales; financial derivatives such as options, swaps, futures contracts, etc.

A small but vocal group of people, primarily libertarians and Constitutionalists, advocate for a return to the gold standard (the elimination of the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is basically that monetary policy is fraught with risk and these risks will result in drastic harm to the populace should monetary policy fail. Others see another problem with our current monetary policy. The problem for them is not that our money has nothing physical to define its value, but that fractional reserve lending of that money as a debt to the recipient, rather than a credit, causes all but a small proportion of society (including all governments) to be perpetually in debt. In fact, many economists disagree with returning to a gold standard. They argue that doing so would drastically limit the money supply, and throw away 100 years of advancement in monetary policy. The sometimes complex financial transactions that make big business (especially international business) easier and safer would be much more difficult if not impossible. Moreover, shifting risk to different people/companies that specialize in monitoring and using risk can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved. Some have claimed that these arguments lost credibility in the global financial crisis of 2008-2009.

MONEY SUPPLY
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time.[1] There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits (depositors' easily accessed assets on the books of financial institutions).

Money supply data are recorded and published, usually by the government or the central bank of the country. Public and private sector analysts have long monitored changes in money supply because of its possible effects on the price level, inflation and the business cycle. That relation between money and prices is historically associated with the quantity theory of money. There is strong empirical evidence of a direct relation between long-term price inflation and money-supply growth, at least for rapid increases in the amount of money in the economy. That is, a country such as Zimbabwe which saw rapid increases in its money supply also saw rapid increases in prices (hyperinflation). This is one reason for the reliance on monetary policy as a means of controlling inflation. This causal chain is contentious, however: some heterodox economists argue that the money supply is endogenous (determined by the workings of the economy, not by the central bank) and that the sources of inflation must be found in the distributional structure of the economy. In addition to some economists seeing the central bank's control over the money supply as feeble, many would also say that there are two weak links between the growth of the money supply and the inflation rate: first, an increase in the money supply, unless trapped in the financial system as excess reserves, can cause a sustained increase in real production instead of inflation in the aftermath of a recession, when many resources are underutilized. Second, if the velocity of money, i.e., the ratio between nominal GDP monetaryand money supply, changes, an increase in the money supply could have either no effect, an exaggerated effect, or an unpredictable effect on the growth of nominal GDP.

SUPPLY OF MONEY
The supply of money is what gives each dollar its value. All things being equal, the greater the supply, the lesser the value. We can make the same conclusions about shares of stock. If a company announces a 2:1 split, what happens to the price? A 2:1 split just means that the company issues one share of stock for each share in existence thus creating two shares for every one in existence. If you own

100 shares today, you will have 200 shares after the split. Does that mean youll immediately double the value of your holdings? No, because the share price gets cut in half. In other words, if you double the number of shares, the price falls proportionately. Microsoft is currently trading for about $35 per share and has 9.38 billion shares outstanding. What would the company be worth if they increased the number of shares by a factor of 10,000? It would be nearly worthless. As with money, the more stock certificates there are in existence, the lower the value of each share. Money has value because of the relative availability. If money were as plentiful as grains of sand on all the worlds beaches, it would have no value. Just like shares of stock, money is similar in that it symbolizes a claim on assets. If you have a ten-dollar bill, it represents your claim to ten dollars worth of goods or services. However, if that ten-dollar bill represents such a small fraction of all bills in existence, it is virtually worthless. In a similar way, one grain of sand represents an insignificantly small portion of the beach and therefore has no value. At any time, the Fed can count the number of dollars in existence but that is easier said than done since that depends on what were willing to count as money. There are four basic definitions that the Fed uses to measure the supply of money called M1, M2, M3 and L. In fact, in the Federal Reserve booklet, The Federal Reserve System, Purposes & Functions, the Fed gives the following definition of money: "Anything that serves as a generally accepted medium of exchange, a standard of value, and a means of saving or storing purchasing power. In the United States, currency (the bulk of which is Federal Reserve notes) and funds in checking and similar accounts at depository institutions are examples of money." While it's beyond the scope of this course to go into the various pros and cons of the different measures, they are listed here just to emphasize how difficult it is to give a precise definition of the supply of money: 1. M1 is the base measurement of the money supply and includes cash in the hands of the public (currency and coins) plus demand deposits, tourist's checks from non-bank issuers, and other checkable deposits. 2. M2 is equal to M1 plus savings deposits, money market accounts, overnight repurchase agreements issued by commercial banks, overnight Eurodollars, money market mutual funds, and time deposits less than $100,000. 3. M3 equals M2 plus institutionally held money market funds, term repurchase agreements, term Eurodollars, and large time deposits. L,the fourth measure, is equal to M3 plus Treasury bills, commercial papers, banker's acceptances, and very liquid assets such as savings bonds. Almost all short-term, highly liquid assets will be included in this measure called L, which stands for liquidity.

Regardless of how it is measured, an increase in the supply of money puts more spending power in the hands of the consumers, which stimulates demand for goods and services. The Treasury must issue enough securities to provide the amount needed by the economy and the money supply is ultimately limited by the total amount of Treasury securities outstanding.

THE DEMAND FOR MONEY

Is there a limit on the demand for money? Could you ever have too much? While this may be the suggested meaning in the phrase demand for money it is not the way it is used by economists. When economists speak of the demand for money, they mean your desire to hold a given amount of money over a given time. There are three main reasons why people demand to hold money (1) to conduct basic transactions (2) for unexpected events, which is often called a precautionary motive, and (3) for speculation. The first reason, transactions, refers to basic transactions. These include money for food, transportation, tolls, and other miscellaneous known transactions throughout a given time period. For example, if you typically hold an average of $100 in your wallet each week to conduct transactions, that's your transactions demand for money. Precautionary money is held for unexpected transactions such as car repairs or medical bills, although does not need to be limited to serious expenses or needs.

You could hold additional money to take advantage of a computer sale you expect to be happening soon. The speculation motive for holding money is a battle between cash and investments. Cash, by itself, earns no interest and can therefore be expensive to hold (due to the opportunity cost of foregone interest). However, if you think stock and bond prices are relatively low, you could generate a return on your money by putting cash into these investments thats the speculative motive for holding money. Conversely, if interest rates are high, you will want to hold as much cash as possible.

EMPIRICAL MEASURES
Money is used as a medium of exchange, in final settlement of a debt, and as a ready store of value. Its different functions are associated with different empirical measures of the money supply. There is no single "correct" measure of the money supply: instead, there are several measures, classified along a spectrum or continuum between narrow and broad monetary aggregates. Narrow measures include only the most liquid assets, the ones most easily used to

spend (currency, checkable deposits). Broader measures add less liquid types of assets (certificates of deposit, etc.) This continuum corresponds to the way that different types of money are more or less controlled by monetary policy. Narrow measures include those more directly affected and controlled by monetary policy, whereas broader measures are less closely related to monetarypolicy actions. It is a matter of perennial debate as to whether narrower or broader versions of the money supply have a more predictable link to nominal GDP. The different types of money are typically classified as "M"s. The "M"s usually range from M0 (narrowest) to M3 (broadest) but which "M"s are actually used depends on the country's central bank. The typical layout for each of the "M"s is as follows: Type of money M0 MB M1 M2 M3 MZM V V V V

Notes and coins (currency) in circulation (outside Federal Reserve [8] V V Banks, and the vaults of depository institutions) Notes and coins (currency) in bank vaults Federal Reserve Bank credit (minimum reserves and excess reserves) traveler's checks of non-bank issuers demand deposits other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts. savings deposits time deposits less than $100,000 and money-market deposit accounts for individuals large time deposits, institutional money market funds, short-term repurchase and other larger liquid assets V[8] V V

V V

V V

V V

V V

V[9] V

V V

V V

all money market funds

M0: In some countries, such as the United Kingdom, M0 includes bank reserves, so M0 is referred to as the monetary base, or narrow money. MB: is referred to as the monetary base or total currency. This is the base from which other forms of money (like checking deposits, listed below) are created and is traditionally the most liquid measure of the money supply. M1: Bank reserves are not included in M1. M2: represents money and "close substitutes" for money. M2 is a broader classification of money than M1. Economists use M2 when looking to quantify the amount of money in circulation and trying to explain different economic monetary conditions. M2 is a key economic indicator used to forecast inflation. M3: Since 2006, M3 is no longer tracked by the US central bank. However, there are still estimates produced by various private institutions. (M2 +large deposits and other large, longterm deposits) MZM: Money with zero maturity. It measures the supply of financial assets redeemable at par on demand.

The ratio of a pair of these measures, most often M2/M0, is called an (actual, empirical) money multiplier.

QUALITATIVE MEASURES OF MONETARY POLICY

The qualitative measures do not regulate the total amount of credit created by the commercial banks. These measures make distinction between good credit and bad credit and

regulate only such credit, which creates economic instability. Therefore, qualitative measures are known as the selective measures of credit control.

Qualitative credit control measures include:

(i) Prescription of margin requirements (ii) Consumer credit regulation (iii) Moral suasion (iv) Direct action (i) Prescription of margins requirements: Generally, commercial banks give loan against stocks or securities. While giving loans against stocks or securities they keep margin. Margin is the difference between the market value of a security and its maximum loan value. Let us assume, a commercial bank grants a loan of Rs. 8000 against a security worth Rs. 10,000. Here, margin is Rs. 2000 or 20%. If central bank feels that prices of some goods are rising due to the speculative activities of businessmen and traders of such goods, it wants to discourage the flow of credit to such speculative activities. Therefore, it increases the margin requirement in case of borrowing for speculative business and thereby discourages borrowing. This leads to reduction is money supply for undertaking speculative activities and thus inflationary situation is arrested. On other contrary, central bank can encourage borrowing from the commercial banks by reducing the margin requirement. When there is a grater flow of credit to different business activities, investment is increased. Income of the people rises. Demand for goods expands and deflationary situation is controlled. Thus, margin requirement is a significant tool in the hands of central bank to counter-act inflation and deflation.

(ii) Consumer credit regulation: Now-a-days, most of the consumer durables like T.V., Refrigerator, Motorcar, etc. are available on installment basis financed through bank credit. Such credit made available by commercial banks for the purchase of consumer durables is known as consumer credit. If there is excess demand for certain consumer durables leading to their high prices, central bank can reduce consumer credit by (a) increasing down payment, and (b) reducing the number of installments of repayment of such credit.

On the other hand, if there is deficient demand for certain specific commodities causing deflationary situation, central bank can increase consumer credit by (a) reducing down payment and (b) increasing the number of installments of repayment of such credit. (iii) Moral suasion: Moral suasion means persuasion and request. To arrest inflationary situation central bank pursuades and request the commercial banks to refrain from giving loans for speculative and non-essential purposes. On the other hand, to counteract deflation central bank pursuades the commercial banks to extend credit for different purposes. Central bank also appeals commercial banks to extend their wholehearted co-operation to achieve the objectives of monetary policy. Being the monetary authority directions of the central bank are usually followed by commercial banks. (v) Direct Action: This method is adopted when a commercial bank does not co-operate the central bank in achieving its desirable objectives. Direct action may take any of the following forms: Central banks may charge a penal rate of interest over and above the bank rate upon the defaulting banks; Central bank may refuse to rediscount the bills of those banks which are not following its directives; Central bank may refuse to grant further accommodation to those banks whose borrowings are in excess of their capital and reserves.

QUANTITATIVE MEASURES OF MONETARY POLICY

The quantitative measures regulate the total quantity of credit without taking into account the uses to which such credit is put. Such measures affect the economy as a whole and are nondiscriminatory in character.

There are three quantitative measures:

i. Bank rate

ii. Open market operations iii. Variable cash reserve ratio. (i) Bank rate: Bank rate is the official minimum rate of interest at which central bank lends money to commercial banks. So bank rate is known as the central banks lending rate. Usually the central bank lends to commercial banks by re-discounting their bills of exchange. Bank rate is also known as the re-discount rate. In order to correct excess demand or inflationary situations, Central Bank increase bank rate. Consequent upon an increase in bank rate, commercial banks raise their lending rate to the general public. This makes the borrowing from commercial banks costlier. Therefore, businessmen and enterprises reduce borrowing and cut investment. As a result, income of the people declines and demand for goods is curtailed. In this way, the situation of excess demand or inflation is checked. Likewise, central bank can control the state or deficient demand or deflation by reducing the bank rate. (ii) Open Market Operations: Open market operation refers to the purchase and sale of Government securities by the Central bank in open market. In order to correct the excess demand or inflation, the central bank sells securities to the commercial banks and general public. When commercial banks buy securities, their cash reserves are reduced directly. When people buy securities, they make large withdraw of cash from commercial banks. Here their cash reserves are diminished indirectly. Consequently, commercial banks capacity to create credit is curtailed. This leads to a reduction in the volume of investment on the part of businessmen and entrepreneurs and a decline in national income. As a result, the state of excess demand or inflation is checked. On the contrary, central bank can correct the state of deficient demand or deflation by purchasing securities in the open market. (iii) cash reserve ratio: According to the law, each commercial bank has to keep a part of its deposits with the central bank is a ratio known as the cash reserve ratio (CRR). Central bank can increase or decrease this ratio; therefore, it is known as the variable cash this ratio. It is very powerful instrument of credit control.

In order to correct the state of excess demand or inflation central bank increase the cash reserve ratio (CRR). So commercial banks are required to keep larger amount of cash reserves with the central bank and consequently, amount of cash available with them is reduced. This leads to a decline in the credit creating capacity of commercial banks. When smaller amount of credit is given to the entrepreneurs, investment falls. Consequently, national income declines and the state of excess demand are checked. Likewise, the central bank can correct the state of deficient demand or deflation by reducing the cash reserve ratio (CRR). However, the quantitative measures of credit control are not so much effective in according excess demand and deficient demand particularly in less developed countries.

CONCLUSION
When a central bank is "easing", it triggers an increase in money supply by purchasing government securities on the open market thus increasing available funds for private banks to loan through fractional-reserve banking (the issue of new money through loans) and thus the amount of bank reserves and the monetary base rise. By purchasing government bonds (especially Treasury Bills), this bids up their prices, so that interest rates fall at the same time that the monetary base increases.

With "easy money," the central bank creates new bank reserves (in the US known as "federal funds"), which allow the banks lend more. These loans get spent, and the proceeds get deposited at other banks. Whatever is not required to be held as reserves is then lent out again, and through the "multiplying" effect of the fractional-reserve system, loans and bank deposits go up by many times the initial injection of reserves. In contrast, when the central bank is "tightening", it slows the process of private bank issue by selling securities on the open market and pulling money (that could be loaned) out of the private banking sector. By increasing the supply of bonds, this lowers their prices and raises interest rates at the same time that the money supply is reduced. This kind of policy reduces or increases the supply of short term government debt in the hands of banks and the non-bank public, lowering or raising interest rates. In parallel, it increases or reduces the supply of loanable funds (money) and thereby the ability of private banks to issue new money through issuing debt.

Demand and supply of money in a developing economy: a structural analysis for india:
In developed countries, in general, discrepancies between physical and monetary flows of production, consumption and income are only marginal. In developing countries sizable proportions of income and consumption originate through non-monetary transactions like self consumption of goods and services and barter trade. These proportions generally decline with economic development. The transaction demand for money therefore increases party because of growth of national income and partly because of a rise in the degree of monetization. As such, the relavant concept of income in monetory analysis of developing countries is a monetized component of national income and not total national income. This factor has been generally ignored in empirical studies.

However, the rate of growth of degree of monetization may decline progressively with economic development. For an empirical analysis of this issue see bhattacharya (1973). Variations in degrees of monetization can also explain the international differences in income velocity of money (melitz and correa, 1970). Probably because of the lack of data on monetized income. In this study we have estimated the money demand function with monetized income data and have shown how it differs from that estimated with national income data.

Another important characteristic of developing economics is the dual nature of oraganized and unorganized money market interest interest rates. In the organized market the speculative demand for money varies with interest rates on financial asets. Interest rates in the unorganized market are primarily related to risks and returns on real assets which having inelastic supply like land. The supply of money does not effect these interest rates significantly. Therefore , the Keynesian liquidity preference hypothesis may hold good in developing economics, if at all, in the organized market rather than the unorganized market. In section 2 we formulate the money supply and the money demand functions for the Indian economy within the frame work of a hicks-hansen-modigliani-type model. The ordinary least squares(OLS) and the two-stage least squares(2-SLS) estimates of these functions with alternative definitions of money are analysed in section 3. The impact of non-monetized income and unorganized market interest rate on money demand are analysed in section 4. Section 5 is developed to the analysis of forecasts and multipliers of money proper(currency plus demand deposits). The main conclusions are presented in section 6.