Why are Government Cash Balances with the Central Bank not included in the Monetary Base?

In my previous post What is the Monetary Base, I explained that the Monetary base of an economy = Cash held by the public (i.e. cash held outside the banking system, the central bank and the government) + Cash held by banks (at their branches) + Banks' reserves with the Central bank. 

This Monetary base is the total amount of physical cash available in the economy, and is quite literally the 'base' on which the banking system creates the economy's money supply.

After one understands what the Monetary base is, it’s natural to question why cash in government accounts with the Central Bank is not included in the nation's Monetary base. Before I answer this, I’m going to give the readers a little background about India's Central Bank - the Reserve Bank of India (RBI), and its relationship with the Indian government.

RBI’s role as Banker to the Government

The RBI is the banker to the central government of India. As far as state governments are concerned, per the RBI Act, the RBI can transact the banking business of a state government through an agreement with this government. All states except Sikkim have entered into agreements with the RBI and the RBI performs the role of banker to these governments as well.

Being the banker to the central government entails accepting monies and making payments on behalf of the government, carrying out exchange, remittance, clearing and other banking functions, investing surplus cash of the government over and above the minimum cash balance requirement, managing data on direct tax collections by various RBI offices, management of public debt, and giving advice to the government on policy matters. 

Central Government’s Accounts with the RBI

The following accounts of the central government are maintained in all the regional offices of the RBI:

1. Central Government - Civil

2. Railway Fund

3. Post Fund

4. Telecommunication Fund

5. Defence Fund

6. Departmentalised Ministries

7. Agency Transaction Account

The Principal account of these accounts are maintained at the Central Accounts Section (CAS), RBI, Nagpur.

The central government is required to maintain a minimum daily cash balance of Rs. 10 crore with the RBI. On Fridays, March 31 (FY end) and June 30 (RBI accounting yr end), the minimum balance must be Rs. 100 crore. 

Why Government Cash Balances with the Central Bank are not included in the Monetary Base

The RBI and the central government are producers of money. RBI issues all paper currency, while the government issues all coins and 1 rupee notes. Now, as we discussed in my previous post What is the Monetary Base, the monetary base is the physical currency that these producers release to the public and banks. Hence, in order to be part of the monetary base, this currency has to leave these producers and find its way to the public or banks. 

This is why the government’s cash balances lying with the RBI are not part of the monetary base. They become part of the base when the government spends from these balances i.e. pays salaries to government employees or spends money on public works projects. Similarly, when we pay taxes to the government, this currency is wiped from the monetary base because it now lies in the government’s account with the RBI.

If you haven’t understood the logic, think of a producer of cars, say Maruti. When one asks, “what is the number of cars in India?”, we count the cars delivered by Maruti to its customers (these are out on the streets), but not those lying in its factory, which haven’t yet be delivered or those that have been returned for some reason. We simply don’t count the stock of product lying with a producer while counting the quantity of product out in the market. This is also why we do not include the cash lying in RBI's printing presses in the nation's monetary base. 

This post ends here, but I’d encourage interested readers to read How Advance Tax Payments and Government Spending Impact System Liquidity. While I did this post earlier in the year mostly from a liquidity perspective, it’ll make more sense after reading the current post.

What is the Monetary Base?

This is a pretty fundamental question, crucial to understanding how money supply is created in an economy. Yet, I find that it isn’t answered clearly or rather completely, on many educational websites as well as in certain textbooks. So here’s my attempt at a lucid and comprehensive explanation. 

First things first, the ‘Monetary base’ is also called ‘High powered money’, ‘Reserve money’, ‘Base money’, ‘Money base’, ‘Central bank money’ or ‘M0’. 

Very simply, the Monetary base in an economy refers to the physical stock of currency (notes + coins) that is held by the public (this includes everyone except the Central Bank, all other banks in the country and the government) and the commercial banks.

More precisely, the Monetary base = Currency held by the public + Cash held by banks + Banks' reserves with the Central Bank. 

The Reserve Bank of India (RBI) defines it as: 

Monetary base = 1. Currency in Circulation +

                               2. Bankers’ Deposits with RBI +
                               3. Other Deposits with RBI

You'll see that while the terminology is a little different, RBI's definition is the same as the general one provided above. Before I talk about of each these components in detail, let’s take a quick peek at their quantitative significance. 

Monetary base (or Reserve money) Components for India (Rs Billion)

Source: RBI weekly statistical supplement, 4th Nov ’16


Source: RBI weekly statistical supplement, 4th Nov '16
We’ve used data for 28th Oct '16

As evident from the charts above, Currency in circulation comprises almost 4/5th of the Monetary base, while Bankers’ deposits with RBI comprise the remaining 1/5th. Other Deposits with RBI are ~1% of the base, and are therefore insignificant for the purpose of our discussion. That said, I’ll still touch upon them later for the sake of completeness.

1. Currency in Circulation

Currency in circulation = Currency with the public +
                                              Cash held by banks

This makes sense if you think about it. While the actual currency circulating in the economy obviously includes the currency held by the public (everyone outside of the banking system, the central bank and the government), it should also include the cash held by commercial banks, where the public has deposits. 

Ofcourse, if you have Rs 100 deposited in a bank, that does not mean that the bank has this Rs. 100 in physical cash. The bank has lent out most of your money to borrowers, and has probably just Rs 5 lying in cash to meet any sudden withdrawal requirements. But that’s a discussion for a subsequent post. 

Note: currency = cash; the terms are interchangeable 

2. Bankers’ Deposits with RBI (or Banks' Reserves with the Central Bank) 

Before I explain what Bankers’ Deposits with the RBI mean, I’m going to provide some much-needed context. 

So, by ‘Cash held by banks’ (part of Currency in circulation), I meant cash held by banks at their branches in order to meet daily withdrawal needs and maintain a cushion for other contingencies. But this is not the only reason why banks need to hold cash. They also need to satisfy the RBI’s Cash Reserve Ratio (CRR) requirement (most Central Banks in the world have this requirement). 

RBI’s CRR requirement stipulates that all banks need to maintain a certain % of their total deposits in cash with the RBI. Read my post CRR and SLR for details. The CRR currently stands at 4%. 

So let’s say a bank branch gets Rs. 20 lakhs in deposits in a day. Of this amount, Rs. 5 lakhs is consumed in meeting cash withdrawal and ATM replenishment needs. There’s Rs. 15 lakh left. Let’s assume the branch always keeps Rs. 10 lakhs in cash, in order to meet withdrawal requirements as well as maintain a little cushion. As a result, the branch will keep Rs 10 lakh at it's premises, and send the remaining Rs. 5 lakh to a “currency chest”.

A currency chest is a designated branch of a bank that collects cash on behalf of the RBI. Once cash is sent by a branch to the currency chest, it is deemed deposited with the RBI as on that day. This  amount is credited to the bank's (whose branch sent the cash) Current account with the RBI. Note: this cash counts towards satisfying the bank’s CRR requirement. 

With that background, I’m now going to explain what Bankers’ deposits with RBI refer to. Bankers’ deposits with the RBI are current account deposits that scheduled commercial banks hold with the RBI. When a bank deposits cash in a currency chest, this amount is credited to their current account. A bank usually maintains one Principal account, which is used to maintain CRR balances, and many subsidiary accounts with the RBI for inter-bank clearing, currency chest and other operations.

When you add up the balances in all these accounts, you get each bank’s total current account deposits with the RBI. The summation of all such deposits across the banking system, gives you total Bankers’ deposits with the RBI (or total banks' reserves with the RBI). As we’ve seen above, these deposits form 20% of the Indian monetary base. 

Finally, whenever banks are in need of cash, they withdraw currency from currency chests. When this happens, their current account balances with the RBI are debited by that amount. 

3. Other Deposits with RBI

This is a miniscule component of the monetary base (1% as on Oct 28th) and is usually ignored. It includes deposits held at the RBI by foreign central banks, foreign governments, international agencies such as the World Bank and IMF, and certain non-bank financial institutions (eg. primary dealers). 

Putting it all together

In conclusion, the Monetary base = Cash held by the public (i.e. cash held outside the banking system, the Central Bank and the government) + Cash held by banks (at their branches) + Banks' reserves with the Central Bank. 

This Monetary base is the total amount of physical cash available in an economy, and is quite literally the “base” on which the banking system of an economy creates the economy's money supply.

Does the Quantity Theory of Money derive from the Quantity Equation?

The short answer is no. 

A quick look at the historical origins of the Quantity Theory of Money (QTM) and the Quantity Equation makes things clear. 

Historical Origins

QTM traces its origin to as far back as the 16th century when Jean Bodin (French philosopher and economist) and some others asserted that the European inflation of the time was being driven in significant part by the inflow of gold and silver (metals used as currency) from South America. Subsequently, influential thinkers including John Locke (1632-1704), Richard Cantillon (1680s - 1734) and David Hume (1771-76) did important work on QTM, adding substance to the theory. By the 1800s, despite opposition, QTM had become the largely accepted theoretical guide to monetary policy. 

The Quantity equation came much later. Since the sharpest minds through history have often worked and come up with the same formulations around the same time, attribution is sometimes a complicated affair. While John Stuart Mill (1806-73) developed the concept of the “Equation of Exchange” (what the Quantity equation was originally called), the mathematical formulation of the Equation of Exchange is attributed to Irving Fisher (1867-1947), who in turn credits Simon Newcomb (Canadian-American mathematician) as the first thinker to come up with this equation. 

The Equation of Exchange 

Given below is the original ‘Equation of Exchange’ (the form that Newcomb came up with and Fisher adopted):

MV=PT                    where

M = the stock of money in circulation 

V = velocity of circulation of money or the number of times a unit of money changes hands during the year

P = general price level 

T = total no. of transactions carried out during the year

Irving Fisher’s Contribution 

What Fisher did (and why history remembers him), was take Newcomb’s equation and formulate the Quantity Theory of Money around this equation. He gave QTM a mathematical framework that did not exist before, and in doing so, allowed those who came after him, to empirically test QTM in a scientific way. 

This framework also made it possible to clearly state one’s assumptions. Fisher assumed that V and T were constant or stable. Based on these assumptions, he theorized that the general price level (P) varies in direct proportion to the quantity of money in circulation (M). Makes complete sense; if MV=PT, and V and T are stable, P has to be directly proportional to M. 

Naturally, this framework also made it easier to refute the theory by attacking these assumptions. For example, if V or T are not stable, then QTM as it is traditionally formulated, falls apart. 

Conclusion

The Quantity Theory of Money does not derive from the Quantity Equation, since QTM was around centuries before the Quantity Equation was formulated and employed to give the theory mathematical form and vigour. The Quantity equation is simply a tool employed by economists to justify the validity or the invalidity of QTM by critically analyzing the theory’s assumption and its fit with empirical data.