Money Market: formula sheet

Key formulas

Money market period

Money market = funds for up to 1 year

Capital market = funds for more than 1 year. This is the core difference.

Nature of instruments

Short maturity + high liquidity + low risk

Treasury bills, call money, commercial paper, certificates of deposit and commercial bills fit this pattern.

Money market vs capital market

Money market: short-term, working capital, low risk. Capital market: long-term, fixed capital, higher risk

Use this as a quick comparison for difference-based questions.

Total demand for money

L = L1 + L2

L1 = transaction + precautionary demand (depends on income, Y). L2 = speculative demand (depends on interest rate, r).

Functional form

L = L1(Y) + L2(r)

L1 rises with Y. L2 falls as r rises.

Bond price and interest rate

Bond price = Annual interest payment ÷ Market interest rate

Applies to a perpetual bond with fixed payment. Price and rate move in opposite directions.

Money-bond rule

Interest rate ↑ → bond price ↓ → speculative demand for money ↓

The reverse holds when the interest rate falls.

Liquidity trap

At a very low interest rate, speculative demand for money becomes perfectly elastic

With the interest rate on the vertical axis and money demand on the horizontal axis, the liquidity preference curve turns horizontal. Extra money supply does not lower the rate further.

Money supply

M = m × H

M is money supply, m is the money multiplier, H is high-powered money.

Money multiplier

m = M ÷ H

Ratio of money supply to high-powered money.

Simple deposit multiplier

m = 1 ÷ CRR

Use when the public holds no cash and banks keep only the required reserve. CRR must be in decimal form, e.g. 10% = 0.10.

Multiplier with currency holding

m = (1 + c) ÷ (c + r)

c = currency-deposit ratio, r = reserve-deposit ratio. Use only when both ratios are given.

Total deposits from an initial deposit

Total deposit creation = Initial deposit × (1 ÷ CRR)

Assumes full lending and no cash leakage. New credit created = total deposits − initial deposit.

High-powered money

H = Currency held by public + Bank reserves (cash in hand + deposits with RBI)

Also called reserve money or monetary base.

M1 (narrow money)

M1 = Currency with public + Demand deposits with banks + Other deposits with RBI

Most liquid measure. Currency means notes and coins held by the public, not by banks.

M2

M2 = M1 + Savings deposits with post office savings banks

Adds only post office savings deposits to M1.

M3 (broad money)

M3 = M1 + Time deposits with banks

Also called aggregate monetary resources. M3 builds on M1, not on M2.

M4

M4 = M3 + Total post office deposits (excluding NSCs)

Widest and least liquid of the four.

Liquidity order

M1 is the most liquid; M4 is the least liquid

M1 < M2, M1 < M3 and M3 < M4 always hold. M2 and M3 both branch from M1, so M3 is not built on M2. Compare M2 and M3 from the data.

Equilibrium condition

Md = Ms

The equilibrium interest rate is the rate at which the quantity of money demanded equals the quantity of money supplied.

Excess supply of money

Ms > Md → interest rate falls

People buy bonds, bond prices rise, and the rate moves down to equilibrium.

Excess demand for money

Md > Ms → interest rate rises

People sell bonds, bond prices fall, and the rate moves up to equilibrium.

Bond price and interest rate

Bond price ↑ ⇔ interest rate ↓

They move in opposite directions. Use this to explain the adjustment.

Direction of shifts

Ms ↑ → r ↓; Ms ↓ → r ↑; Md ↑ → r ↑; Md ↓ → r ↓

Holds when only one curve shifts and the other stays unchanged. If both shift, the result can be unclear.

T-bill maturities

91 days, 182 days, 364 days

Standard tenors of treasury bills. They are issued at a discount and redeemed at face value.

Discount instrument return

Return = Face value − Issue price

T-bills, CP and CDs give no coupon. Your gain is the difference between redemption value and purchase price.

Call and notice money

Call money = 1 day; Notice money = 2 to 14 days

Both are interbank borrowing. Over 14 days is term money.

Repo direction

Repo: RBI lends, liquidity ↑; Reverse repo: RBI borrows, liquidity ↓

Always view the transaction from the RBI's side.

Repo cost

Repurchase price = Sale price + Interest for the period

A repo is a sale with an agreement to repurchase at a higher price.

Quick revision

• The money market deals in short-term funds, generally up to one year.
• Money demand falls as the interest rate rises, all else equal.
• Equilibrium interest rate is where money demand equals money supply.
• If money supply rises and demand is unchanged, the interest rate falls.
• Money multiplier is the ratio of total money supply to high-powered money.
• A higher reserve ratio generally lowers the money multiplier.
• M1 is the most liquid measure and M4 the least liquid among the four.
• M1 = currency + demand deposits + other deposits with RBI. M2 = M1 + post office savings deposits. M3 = M1 + net time deposits of banks. M4 = M3 + total post office deposits. M3 does not contain M2.
• Common instruments include treasury bills, call money, commercial paper and certificates of deposit.
• Raising the repo rate makes borrowing from RBI costlier and tightens liquidity.
• Raising CRR reduces the funds banks can lend.
• Open market sales of securities absorb money; purchases inject money.

Common mistakes

• Saying the money market deals in long-term funds. Fix: Remember money market = up to one year. Anything beyond one year is the capital market.
• Thinking the money market is a single physical location. Fix: Treat it as a network of institutions and participants connected by trading, often electronically.
• Saying speculative demand rises when the interest rate rises. Fix: Remember: high rate, bonds are cheap, buy bonds, hold less cash. The relation is inverse.
• Treating precautionary demand as depending on interest rate. Fix: Only the speculative motive is interest-based in Keynes's account. Transaction and precautionary depend mainly on income.
• Using CRR as 10 instead of 0.10 in 1 ÷ CRR. Fix: Convert to a decimal first, or use the reciprocal: 1 ÷ 10% = 10.
• Treating money supply and high-powered money as the same thing. Fix: Remember H is the base created by the RBI. M = m × H is larger because banks multiply it.
• Building M3 on top of M2. Fix: Remember M3 = M1 + time deposits. M2 and M3 both branch from M1. Only M4 builds on M3.
• Treating M2 as larger than M3 or in a strict chain with it. Fix: M2 and M3 both branch from M1, so M3 is not built on M2. M1 < M2 and M1 < M3 < M4 always hold. Compare M2 and M3 from the data.
• Drawing money supply as a upward sloping curve in the basic model. Fix: In this model the central bank fixes the money stock, so supply is a vertical line. It does not change with the interest rate.
• Saying a rise in money supply raises the interest rate. Fix: More money supply with unchanged demand means excess money. People buy bonds, and the rate falls.

Exam tips

• Memorise the one-year dividing line between the money market and the capital market. Many questions rest on it.
• Learn the list of money market instruments, as the exam often asks you to pick or reject one.
• For NOT or EXCEPT questions, verify each option against the features before marking.
• Link the money market to RBI policy and liquidity, because functions are often asked in this context.
• Do not guess when you have no idea. Each wrong answer costs 0.25 marks.
• Learn the motive-to-determinant pairs cold. Most MCQs test only this link.
• Practise bond price questions with simple numbers such as ₹60 interest and 5% or 10% rates. Check the direction of change.
• Watch the wording 'movement along' versus 'shift of' the curve.