Money Supply and its Determinants

Introduction 
 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 at any moment is the total amount of money in the economy. There are three alternative views regarding the definition or measures of money supply.

·         The most common view is associated with the traditional and Keynesian thinking which stresses the medium of exchange function of money.

Forms of MS

M1 = C + DD   (Demand Deposit)

M2= M1 +TD (Time Deposit)

M3= M2 + Liabilities of NBAFI

Determinant of MS

1. High powered Money (H= C + R), (M = C + D)

The H Theory of Money Supply’. However, it is more popularly called ‘Money-multiplier Theory of Money Supply’ because it explains the determination of money supply as a certain multiple of the high- powered money (M =m * H)

  

2. Money Multiplier:

·         Money multiplier is the degree to which money supply is expanded as a result of the increase in high-powered money. Thus

·         m = M/H                                              Rearranging we have, M = H.m

·         Change in the high-powered money is decided and controlled by central Bank, the money multiplier determines the extent to which decision by central Bank regarding the change in high-powered money will bring about change in the total money supply in the economy

·         m= Cr + 1 /Cr +rr(t +1)

From above it follows that money supply in the economy is determined by the following:

o   H, that is, the amount of high-powered money, which is also called reserve money

o   r, that is, cash reserve ratio of banks (i. e., ratio of currency reserves to deposits of the banks)

o   This cash reserve ratio of banks determines the magnitude of deposit multiplier.

o   k, that is, currency-deposit ratio of the public.

3. Cash Reserve Ratio of the Banks and the Deposit Multiplier (CRR)

Because 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 (CRR increase MS decrease)

4. Currency-Deposit Ratio of the Public and Money Multiplier (Cr)    

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.

Conclusion

·         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.

·         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 money supply in a country can be changed by Central Bank by undertaking open market operations, changing minimum required currency reserve-deposit ratio, and by varying the bank rate. The main source of growth in money supply in India is creation of credit by central Bank for Government for financing its budget deficit and thus creating high-powered money.

·         Further, though the required currency reserve-deposit ratio of banks can be easily varied by CB, the actual currency reserve-deposit ratio cannot be so easily varied as reserves maintained by banks not only depend on minimum required cash reserve ratio but also on their willingness to hold excess reserves.

·         Lastly, an important noteworthy point is that though money multiplier does not show much variation in the long run, it can change significantly in the short run causing large variations in money supply. This unpredictable variation in money multiplier in the short run affecting money supply in the economy prevents the Central Bank of a country from controlling exactly and precisely the money supply in the economy.