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Money Supply: Definition, Determinants and Other Information | Economics

BREAKING DOWN 'Money Supply'

❶If m is fairly stable, the central bank can manipulate the money supply M by manipulating H. But the supply of money varies directly with changes in the high-powered money.

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What is the 'Money Supply'


Growth of money supply is an important factor not only for acceleration of the process of economic development but also for the achievement of price stability in the economy. There must be controlled expansion of money supply if the objective of development with stability is to be achieved. A healthy growth of an economy requires that there should be neither inflation nor deflation. Inflation is the greatest headache of a developing economy. A mild inflation arising out of the creation of money by deficit financing may stimulate investment by raising profit expectations and extracting forced savings.

But a runaway inflation is highly detrimental to economic growth. The developing economies have to face the problem of inadequacy of resources in initial stages of development and it can make up this deficiency by deficit financing. But it has to be kept strictly within safe limits.

Thus, increase in money supply affects vitally the rate of economic growth. In fact, it is now regarded as a legitimate instrument of economic growth. Kept within proper limits it can accelerate economic growth but exceeding of the limits will retard it. Thus, management of money supply is essential in the interest of steady economic growth. By money supply we mean the total stock of monetary media of exchange available to a society for use in connection with the economic activity of the country.

According to the standard concept of money supply, it is composed of the following two elements: Before explaining these two components of money supply two things must be noted with regard to the money supply in the economy. First, the money supply refers to the total sum of money available to the public in the economy at a point of time. That is, money supply is a stock concept in sharp contrast to the national income which is a flow representing the value of goods and services produced per unit of time, usually taken as a year.

Secondly, money supply always refers to the amount of money held by the public. In the term public are included households, firms and institutions other than banks and the government. The rationale behind considering money supply as held by the public is to separate the producers of money from those who use money to fulfill their various types of demand for money.

Since the Government and the banks produce or create money for the use by the public, the money cash reserves held by them are not used for transaction and speculative purposes and are excluded from the standard measures of money supply.

This separation of producers of money from the users of money is important from the viewpoint of both monetary theory and policy. In order to arrive at the total currency with the public in India we add the following items: It is worth noting that cash reserves with the banks has to be deducted from the value of the above three items of currency in order to arrive at the total currency with the public.

It may further be noted that these days paper currency issued by Reserve Bank of India RBI are not fully backed by the reserves of gold and silver, nor it is considered necessary to do so. Full backing of paper currency by reserves of gold prevailed in the past when gold standard or silver standard type of monetary system existed. According to the modern economic thinking the magnitude of currency issued should be determined by the monetary needs of the economy and not by the available reserves of gold and silver.

Under this system, minimum reserves of Rs. RBI is not bound to convert notes into equal value of gold or silver. In the present times currency is inconvertible.

Another important thing to note is that paper currency or coins are fiat money, which means that currency notes and metallic coins serve as money on the bases of the fiat i. In other words, on the authority of the Government no one can refuse to accept them in payment for the transaction made.

That is why they are called legal tender. The other important component of money supply are demand deposits of the public with the banks. These demand deposits held by the public are also called bank money or deposit money. Deposits with the banks are broadly divided into two types: Demand deposits in the banks are those deposits which can be withdrawn by drawing cheques on them.

Through cheques these deposits can be transferred to others for making payments from whom goods and services have been purchased. Thus, cheques make these demand deposits as a medium of exchange and therefore make them to serve as money. It may be noted that demand deposits are fiduciary money proper. Fiduciary money is one which functions as money on the basis of trust of the persons who make payment rather than on the basis of the authority of Government. Thus, despite the fact that demand deposits and cheques through which they are operated are not legal tender, they function as money on the basis of the trust commanded by those who draw cheques on them.

They are money as they are generally acceptable as medium of payment. Bank deposits are created when people deposit currency with them. But far more important is that banks themselves create deposits when they give advances to businessmen and others.

On the basis of small cash reserves of currency, they are able to create a much larger amount of demand deposits through a system called fractional reserve system which will be explained later in detail. In the developed countries such as USA and Great Britain deposit money accounted for over 80 per cent of the total money supply, currency being a relatively small part of it.

This is because banking system has greatly developed there and also people have developed banking habits. On the other hand, in the developing countries banking has not developed sufficiently and also people have not acquired banking habits and they prefer to make transactions in currency. However in India after 50 years of independence and economic development the proportion of bank deposits in the money supply has risen to about 50 per cent.

Several definitions of money supply have been given and therefore various measures of money supply based on them have been estimated. First, different components of money supply have been distinguished on the basis of the different functions that money performs.

For example, demand deposits, credit card and currency are used by the people primarily as a medium of exchange for buying goods and services and making other transactions. Obviously, they are money because they are used as a medium of exchange and are generally referred to as M 1. Another measure of money supply is M 3 which includes both M 1 and time deposits held by the public in the banks.

Time deposits are money that people hold as store of value. The main reason why money supply is classified into various measures on the basis of its functions is that effective predictions can be made about the likely effects on the economy of changes in the different components of money supply.

For example, if M 1 is increasing firstly it can be reasonably expected that people are planning to make a large number of transactions. On the other hand, if time-deposits component of money supply measure M 3 which serves as a store of value is increasing rapidly, it can be validly concluded that people are planning to save more and accordingly consume less. Therefore, it is believed that for monetary analysis and policy formulation, a single measure of money supply is not only inadequate but may be misleading too.

Hence various measures of money supply are prepared to meet the needs of monetary analysis and policy formulation. Recently in India as well as in some developed countries, four concepts of money supply have been distinguished. The definition of money supply given above represents a narrow measure of money supply and is generally described as M 1. From April , the Reserve Bank of India has adopted four concepts of money supply in its analysis of the quantum of and variations in money supply.

These four concepts of measures of money supply are explained below. The money supply is the most liquid measure of money supply as the money included in it can be easily used as a medium of exchange, that is, as a means of making payments for transactions. Currency with the public C in the above measure of money supply consists of the following: Note that in measuring demand deposits with the public in the banks i. In the other deposits with Reserve Bank of India i. It may be noted that other deposits of Reserve Bank of India constitute a very small proportion less than one per cent.

M2 is a broader concept of money supply in India than M1. In addition to the three items of M1, the concept of money supply M 2 includes savings deposits with the post office savings banks. The reason why money supply M2 has been distinguished from M1 is that saving deposits with post office savings banks are not as liquid as demand deposits with commercial and cooperative banks as they are not chequable accounts. However, saving deposits with post offices are more liquid than time deposits with the banks.

M3 is a broad concept of money supply. In addition to the items of money supply included in measure M1, in money supply M3 time deposits with the banks are also included.

It is generally thought that time deposits serve as store of value and represent savings of the people and are not liquid as they cannot be withdrawn through drawing cheque on them. However, since loans from the banks can be easily obtained against these time deposits, they can be used if found necessary for transaction purposes in this way. Further, they can be withdrawn at any time by forgoing some interest earned on them.

It may be noted that recently M3 has become a popular measure of money supply. The working group on monetary reforms under the chairmanship of late Prof.

Sukhamoy Chakravarty recommended its use for monetary planning of the economy and setting target of the growth of money supply in terms of M3. Therefore, recently RBI in its analysis of growth of money supply and its effects on the economy has shifted to the use of M3 measure of money supply. The measure M4 of money supply includes not only all the items of M3 described above but also the total deposits with the post office savings organisation.

However, this excludes contributions made by the public to the national saving certificates. Let us summaries the four concepts of money supply as used by Reserve Bank of India in the following tabular form: In order to explain the determinants of money supply in an economy we shall use M, concept of money supply which is the most fundamental concept of money supply.

We shall denote it simply by M rather than M 1. This concept of money supply is composed of currency held by the public C p and demand deposits with the banks D. The two important determinants of money supply as described in equation 1 are a the amounts of high-powered money which is also called Reserve Money by the Reserve Bank of India and b the size of money multiplier. We explain below the role of these two factors in the determination of money supply in the economy: The high-powered money which we denote by H consists of the currency notes and coins issued by the Government and the Reserve Bank of India.

A part of the currency issued is held by the public, which we designate as C p and a part is held by the banks as reserves which we designate as R. A part of these currency reserves of the banks is held by them in their own cash vaults and a part is deposited in the Reserve Bank of India in the Reserve Accounts which banks hold with RBI.

Accordingly, the high-powered money can be obtained as sum of currency held by the public and the part held by the banks as reserves. It is worth noting that Reserve Bank of India and Government are producers of the high-powered money and the commercial banks do not have any role in producing this high-powered money H.

However, commercial banks are producers of demand deposits which are also used as money like currency. But for producing demand deposits or credit, banks have to keep with themselves cash reserves of currency which have been denoted by R in equation 2 above.

Since these cash reserves with the banks serve as a basis for the multiple creation of demand deposits which constitute an important part of total money supply in the economy, it provides high-powered-ness to the currency issued by Reserve Bank and Government. A glance at equations 1 and 2 above will reveal that the difference in the two equations, one describing the total money supply and the other high-powered money, is that whereas in the former, demand deposits D are added to the currency held by the public, in the latter it is cash reserves R of the banks that are added to the currency held by the public.

In fact, it is against these cash reserves R that banks are able to create a multiple expansion of credit or demand deposits due to which there is large expansion in money supply in the economy. The theory of determination of money supply is based on the supply of and demand for high- powered money. How the high-powered money H is related to the total money supply is graphically depicted in Fig.

The base of this figure shows the supply of high-powered money H , while the top of the figure shows the total stock of money supply. It will be seen that the total stock of money supply that is, the top is determined by a multiple of the high-powered money H.

It will be further seen that whereas currency held by the public C p uses the same amount of high-powered money, that is, there is one-to-one relationship between currency held by the public and the money supply. In sharp contrast to this, bank deposits D are a multiple of the cash reserves R of the banks which are part of the supply of high-powered money.

That is, one rupee of high- powered money kept as bank reserves gives rise to much more amount of demand deposits. Thus, the relationship between money supply and the high-powered money is determined by the money multiplier. We explain below the precise multiplier relationship between high-powered money and the total stock of money supply.

It follows from above that if there is increase in currency held by the public which is a part of the high-powered money with demand deposits remaining unchanged, there will be a direct increase in the money supply in the economy because this constitutes a part of the money supply. If instead currency reserves held by the banks increase, this will not change the money supply immediately but will set in motion a process of multiple creation of demand deposits of the public in the banks.

Although banks use these currency reserves held by the public which constitutes a part of the high- powered money to give more loans to the businessmen and thus create demand deposits, they do not affect either the amount of currency or the composition of high-powered money. The amount of high-powered money is fixed by RBI by its past actions.

Thus, changes in high-powered money are the result of decisions of Reserve Bank of India or the Government which owns and controls it. Money multiplier is the degree to which money supply is expanded as a result of the increase in high-powered money. Thus money supply is determined by the size of money multiplier m and the amount of high- powered money H.

If we know the value of money multiplier we can predict how much money will change when there is a change in the amount of high-powered money. Ch ange in the high-powered money is decided and controlled by Reserve Bank of India, the money multiplier determines the extent to which decision by RBI regarding the change in high-powered money will bring about change in the total money supply in the economy.

Now, an important question is what determines the size of money multiplier. It is the cash or currency reserve ratio r of the banks which determines deposit multiplier and currency-deposit ratio of the public which we denote by k which together determines size of money multiplier. We derive below the expression for the size of multiplier.

From equation 1 above, we know that total money supply M consists of currency with the public C p and demand deposits with the banks. From the equation 4 expressing the determinants of money supply, it follows that money supply will increase: Bec ause of fractional reserve system, with a small increase in cash reserves with the banks, they are able to create a multiple increase in total demand deposits which are an important part of money supply.

The ratio of change in total deposits to a change in reserves is called the deposit multiplier which depends on cash reserve ratio. Thus deposit multiplier of 10 shows that for every Rs. However, in the real world, with the increase in reserves of the banks, demand deposits and money supply do not increase to the full extent of deposit multiplier. This is for two reasons. First, the public does not hold all its money balances in the form of demand deposits with the banks.

When as a result of increase in cash reserves, banks start increasing demand deposits, the people may also like to have some more currency with them as money balances.

This means during the process of creation of demand deposits by banks, some currency is leaked out from the banks to the people. This drainage of currency to the people in the real world reduces the magnitude of expansion of demand deposit and therefore the size of money multiplier. Suppose the cash reserve ratio is 10 per cent and cash or currency of Rs.

The bank A will lend out Rs. However, if borrower of bank A withdraws Rs. With these new deposits of Rs. The drainage of currency may occur during all the subsequent stages of deposit expansion in the banking system.

The greater the leakage of currency, the lower will be the money multiplier. We thus see that the currency-deposit ratio, which we denote by k, is an important determinant of the actual value of money multiplier.

It is important to note that deposit multiplier works both ways, positively when cash reserves with banks increase, and negatively when the cash reserves with the banks decline. That is, when there is a decrease in currency reserves with the banks, there will be multiple contraction in demand deposits with the banks. In the explanation of the expansion of demand deposits or deposit multiplier we have assumed that banks do not keep currency reserves in excess of the required cash reserve ratio.

The ratio r in the deposit multiplier is the required cash reserve ratio fixed by Reserve Bank of India. However, banks may like to keep with themselves some excess reserves, the amount of which depends on the extent of liquidity i. Therefore, the desired reserve ratio is greater than the statutory minimum required reserve ratio.

Obviously, the holding of excess reserves by the banks also reduces the value of deposit multiplier. Theory of determination of money supply explains how a given supply of high-powered money which is also called monetary base or reserve money leads to multiple expansion in money supply through the working of money multiplier.

We have seen above how a small increase in reserves of currency with the banks leads to a multiple expansion in demand deposits by the banks through the process of deposit multiplier and thus causes growth of money supply in the economy.

Deposit multiplier measures how much increase in demand deposits or money supply occurs as a result of a given increase in cash or currency, reserves with the banks depending on the required cash reserve ratio r if there are no cash drainage from the banking system. But in the real world drainage of currency does take place which reduces the extent of expansion of money supply following the increase in cash reserves with the banks.

Therefore, the deposit multiplier exaggerates the actual increase in money supply from a given increase in cash reserves with the banks. In contrast, money multiplier takes into account these leakages of currency from the banking system and therefore measures actual increase in money supply when the cash reserves with the banks increase. The money multiplier can be defined as increase in money supply for every rupee increase in cash reserves or high-powered money , drainage of currency having been taken into account.

Therefore, money multiplier is less than the deposit multiplier. It is worth noting that rapid growth in money supply in India has been due to the increase in high-powered money H, or what is also called Reserve Money Lastly Reserve Bank of India, the money multiplier remaining almost constant. The latter factors change the proportion of money balances that the public holds as cash.

Changes in business activity can change the behaviour of banks and the public and thus affect the money supply.

Hence the money supply is not only an exogenous controllable item but also an endogenously determined item. We have discussed above the factors which determine money supply through the creation of bank credit. But money supply and bank credit are indirectly related to each other. These savings become deposits of commercial banks who, in turn, lend after meeting the statutory reserve requirements. Thus with every increase in the money supply, the bank credit goes up. It varies from time to time depending on changes in income levels, prices, and subjective factors.

If the velocity of money circulation increases, the bank credit may not fall even after a decrease in the money supply. The central bank has little control over the velocity of money which may adversely affect bank credit.

High-powered money is the sum of commercial bank reserves and currency notes and coins held by the public. The use of high-powered money consists of the demand of commercial banks for the legal limit or required reserves with the central bank and excess reserves, and the demand of the public for currency.

In fact, banks do not advance loans up to the legal limits but precisely less than that. This is to meet unanticipated cash withdrawals or adverse clearing balances. Hence the need arises for maintaining excess reserves by them. The money supply is thus determined by the required reserve ratio and the excess reserve ratio of commercial banks.

Currency held by the public is another component of high-powered money. The demand for currency by the public is expressed as a proportion of bank deposits. The currency ratio is influenced by such factors as changes in income levels of the people, the use of credit instruments by the public, and uncertainties in economic activity. The formal relation between the money supply and high-powered money can be stated in the form of equations as under: The money supply M consists of deposits of commercial banks D and currency C held by the public.

Thus the supply of money,. High-powered money H or monetary base consists of currency held by the public C plus required reserves RR and excess reserves of commercial banks.

The relation between M and H can be expressed as the ratio of M to H. So divide equation 1 by. Equation 7 defines money supply in terms of high-powered money. The equation states that the highter the supply of high-powered money, the higher the money supply. Further, the lower the currency ratio Cr , the reserve ratio RRr , and the excess reserve ratio ERr , the higher the money supply, and vice versa.

The relation between the money supply and high-powered money is illustrated in Figure 1. The horizontal curve Hs shows the given supply of high-powered money.

The curve Hd shows the demand for high-powered money associated with each level of money supply and represents equation 6.

On the contrary, a less than OM money supply will mean less demand for high-powered money. If there is an increase in any one of the ratios Cr or RRr or ERr, there would be an increase in the demand for high-powered money. Equation 9 expresses the money supply as a function of m and H. In other words, the money supply is determined by high powered money H and the money multiplier m. The size of the money multiplier is determined by the currency ratio Cr of the public, the required reserve ratio RRr at the central bank, and the excess reserve ratio ERr of commercial banks.

The lower these ratios are, the larger the money multiplier is. If m is fairly stable, the central bank can manipulate the money supply M by manipulating H. The central bank can do so by open market operations. But the stability of m depends upon the stability of the currency ratio and the reserve ratios RRr and ERr. Or, it depends upon off-setting changes in RRr and ERr ratios. Since these ratios and currency with the public are liable to change, the money multiplier is quite volatile in the short run.

But the supply of money varies directly with changes in the high-powered money. At E, the demand and supply of high-powered money is in equilibrium and money supply is OM. An increase in high- powered money by Re 1 increases by a multiple of Re 1.

Some economists do not take into consideration excess reserves in determining high-powered money and consequently the money supply. But the monetarists give more importance to excess reserves. According to them, due to uncertainties prevailing in banking operations as in business, banks always keep excess reserves. The amount of excess reserves depends upon the interaction of two types of costs: The second cost is in terms of the bank rate which is a sort of penalty to be paid to the central bank for failure to maintain the legal required reserve ratio by the commercial bank.

The excess reserve ratio varies inversely with the market rate of interest and directly with the bank rate. Since the money supply is inversely related to the excess reserve ratio, decline in the excess reserve ratio of banks tends to increase the money supply and vice versa.

Thus the money supply is determined by high-powered money, the currency ratio, the required reserve ratio and the market rate of interest and the bank rate. The monetary base or high-powered money is directly controllable by the central bank. Of course, the money multiplier times the high-powered money always equals the money supply, i.

This formulation tells us how much new money will be created by the banking system for a given increase in the high-powered money. The monetary policy of the central bank affects excess reserves and the high-powered money identically. Suppose the central bank makes open market purchases.

This raises the high-powered money in the form of excess reserves of banks. An increase in money supply that results from it comes from the banking system which creates new money on the basis of its newly acquired excess reserves. Thus this concept tells us that the monetary authorities can control the money supply by changing the high-powered money or the money multiplier. Prior to this till March , the RBI published only one measure of the money supply, M or defined as currency and demand deposits with the public.

This was in keeping with the traditional and Keynesian views of the narrow measure of the money supply. This included M 1 plus time deposits of banks held by the public. But since April , the RBI has been publishing data on four measures of the money supply which are discussed as under: The RBI characterises M 1 as narrow money. The second measure of money supply is M 2 which consists of plus post office savings bank deposits. Since savings bank deposits of commercial and cooperative banks are included in the money supply, it is essential to include post office savings bank deposits.

The majority of people in rural and urban India have preference for post office deposits from the safety viewpoint than bank deposits. The third measure of money supply in India is M 3 which consists of M 1 plus time deposits with commercial and cooperative banks, excluding interbank time deposits. The RBI calls M 3 as broad money.

The fourth measure of money supply is M 4 which consists of M 3 plus total post office deposits comprising time deposits and demand deposits as well. This is the broadest measure of money supply.

Of the four inter-related measures of money supply for which the RBI publishes data, it is M 3 which is of special significance. It is M 3 which is taken into account in formulating macroeconomic objectives of the economy every year. Since M 1 is narrow money and includes only demand deposits of banks along with currency held by the public, it overlooks the importance of time deposits in policy making.

That is why, the RBI prefers M 3 which includes total deposits of banks and currency with the public in credit budgeting for its credit policy. It is on the estimates of increase in M 3 that the effects of money supply on prices and growth of national income are estimated.

In fact M 3 is an empirical measure of money supply in India, as is the practice in developed countries. Of the four measures of money supply in India, M 1 which consists of currency with the public and demand deposits with commercial and cooperative banks, is the most liquid form of money.

They are the most liquid assets. Demand deposits are savings bank accounts and current accounts in banks from which depositors can withdraw cheques for any amount lying in their accounts.

A liquid asset is one which is easily spendable, and transferable at face value anywhere and at any time. It can be turned into the generally acceptable medium of exchange quickly without any risk of loss. They are thus less liquid than money. In India, the majority of people in rural and urban areas prefer to keep their cash in post office savings bank deposits from the safety viewpoint because they think that post offices are government owned and managed.

Still the majority of rural people being illiterate, they prefer post offices to banks even by force of habit. The inclusion of post office savings bank deposits in M 1 is meant to measure the increase in total money supply which affects the economy.

But post office savings bank deposits are less liquid than currency and demand deposits because they cannot be easily withdrawn. There are no chequing facilities, except in metropolitan cities and that too in main post offices. The depositors have to undergo a cumbersome process of cash withdrawals in post offices.

M 3 includes M 1 plus time deposits also known as savings deposits in developed countries with commercial banks and cooperative banks. This is broad money which stresses the store of value function of money along-with the medium of exchange function. Time deposits with banks are less liquid than currency and demand deposits because they are held for a fixed time period at a fixed rate of interest.

So time deposits do possess liquidity but less than demand deposits. The fourth measure of money supply is M 4 which includes M 3 plus total post office deposits comprising time deposits and savings bank deposits. They tend to increase the money supply in the country manifold. But these total post office deposits are less liquid than total bank deposits for the reasons already given in the case of M 2.

If deposits with non-bank financial institutions such as mutual savings banks, building societies, insurance companies, loan associations and other credit and financial institutions are also included along with total post office deposits in M 3, the total money supply would be many times more than what is ordinarily defined as M 4. And if such assets as shares, bonds, government securities, etc. Taking all such assets vis-a-vis money, they differ in the degree of liquidity. Since currency is easily spendable and transferable, and has more stability in value, it possesses the highest degree of liquidity.

Demand deposits of banks are also as liquid as currency because they are chequing accounts and easily serve as medium of exchange. But demand deposits of post offices do not possess the same degree of liquidity as bank deposits.


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Various factors influencing the money supply are discussed below: 1. Monetary Base: Magnitude of the monetary base (B) is the significant determinant of the size of money supply. Money supply varies directly in relation to the changes in the monetary base.

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The supply of money is a stock at a particular point of time, though it conveys the idea of a flow over time. The term ‘the supply of money’ is synonymous with such terms as ‘money stock’, ‘stock of money’, ‘money supply’ and ‘quantity of money’. The supply of money .

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Let us summaries the four concepts of money supply as used by Reserve Bank of India in the following tabular form: Determinants of Money Supply: In order to explain the determinants of money supply in an economy we shall use M, concept of money supply which is . These two broad determinants of money supply are, in turn, influenced by a number of other factors. Various factors influencing the money supply are discussed below: 1. Monetary Base: Magnitude of the monetary base (B) is the significant determinant of the size of money supply.

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Determinant of Money Supply 1. The Determinants of the Money Supply The money multiplier, reserve and currency ratios, and borrowed reserves 2. Equation (6) shows that determinants of money supply are (a) those that effect B, (b) those that effect M since, the monetary base has a multiplied effect on the money supply. Therefore, the monetary base is also called high-powered money.