THE SUPPLY OF MONEY

INTRODUCTION:

MONEY SUPPLY

The supply of money is a stock at their 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. According to this view money supply is' defined
as currency with the public and demand deposits with commercial banks.
Demand deposits are savings and current accounts of depositors in a commercial bank.
They are the liquid form of money because depositors can draw cheque for any amount
lying in their accounts and the hank has to make immediate payment on demand. Demand
deposits with commercial banks plus currency with the public are together denoted as M1
the money supply. This is regarded as a: narrower, definition of the money supply.

The second definition is broader and is associated with the modern quantify theorists
headed by Friedman. Professor Friedman defines the money supply at any moment of time
as "literally the number of dollars people are carrying' around in their pockets, the number
of dollars they have to their credit at banks or dollars they have their credit at banks in the
form of demand deposits, and also commercial bank time deposits." Time deposits are fixed
deposits" of customers in a commercial bank. Such deposits earn a fixed rate of interest
varying with the time period for which the amount is deposited. Money can be withdrawn
before the expiry of that period by paying a penal rate of interest to the bank. So time
deposits possess liquidity and are included in the 1.1l0ney supply by Friedman.
Thus this definition includes M1 plus time deposits of commercial banks in the supply of
money. This wider definition is characterized as M2 in America and M3 in Britain and
India. It stresses the store of value function of mOI1CY or what Friedman says, 'a
temporary abode of purchasing power.

DETERMINANTS OF MONEY SUPPLY

There are two theories of the determination of the money supply. According to the first
view, the money supply is determined exogenously by the central bank. The second view
holds that the money supply is determined endogenously by changes in the economic
activity which affect people's desire to hold currency relative to deposits, the rate of
interest, etc. Thus the determinants of money supply are both exogenous and endogenous
which can be described broadly as: the minimum cash reserve ratio, the level of bank
reserves, and the desire of the people to hold currency relative to deposits. The last two
determinants together are called the monetary base or the high powered money.

1. The Required Reserve Ratio

The required reserve ratio (or the minimum cash reserve ratio or the reserve deposit ratio)
is an important determinant of the money supply. An increase in the required reserve ratio
reduces the supply of money with commercial banks and a decrease in required reserve
 ratio increases the money supply.

2. The Level of Bank Reserves

The level of bank reserves is another determinant of the money supply. Commercial bank
reserves consist of reserves on deposits with the central bank and currency in their tills or
vaults. It is the central bank of the country that influences the reserves of commercial banks
in order to determine the supply of money.

3. Public's Desire to Hold Currency and Deposits

People's desire to hold currency (or cash) relative to deposits in commercial banks also
determines the money supply. If people are in the habit of keeping less in cash and more
in deposits with the commercial banks, the money supply will be large. This is because
banks can create more money with larger deposits. On the contrary, if people do not have
banking habits and prefer to keep their money holdings in cash, credit creation by banks
will be less and, the money supply will be at a low level.

4. Other Factors
The money supply is a function not only of the high-powered money determined by the
monetary authorities, but of interest rates; income and other factors. The latter factors change
the proportion of money balances that the public holds as cash. Changes in business activity
can change the behavior 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.

Conclusion
Money supply and bank credit are indirectly related to each other. When the money supply
increases, a part of it is saved in banks depending upon the depositors' propensity to save.
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. But it may not happen in exactly the same proportion due to the following factors:

(a) The marginal propensity to save does not remain constant. It varies from time to time
depending on changes in income levels, prices, and subjective factors.
(b) Banks may also create more or less credit due to the operation of leakages in the credit
creation process.
(c) The velocity of circulation of money also affects the money supply. 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.
There are two basic ways of measuring money: the "theoretical approach" and the "empirical
approach."

The Theoretical Approach to Money Measurement:

The theoretical approach to money measurement tries to use economic theory to decide which assets
should be included in the measure of money. In particular, the theoretical approach focuses on the
relative "moneyness" of assets -- in particular, the degree to which assets function as mediums of
exchange. Traditionally, advocates of this theoretical approach have argued that only those assets
that clearly function as a medium of exchange should be counted in the measure of money.

Unfortunately, however, many assets function as a medium of exchange to some degree and the
appropriate cut-off point is not clear. More recently, however, economists have argued for a
"weighted aggregate" approach to the measure of money. In the latter approach, all assets functioning
to some degree as a medium of exchange are included in the measure of money.
However, each of these assets is weighted, with assets that function more as a medium of exchange
receiving a relatively larger weight. This eliminates the need to specify a sharp threshold determining
which assets are included or excluded from consideration. However, one is still left with the problem
of how to select specific weight magnitudes for the included assets. The verdict on the reliability and
usefulness of these newer weighted-aggregate measures is still out.

The Empirical Approach to Money Measurement:

The empirical approach to the measurement of money takes a more pragmatic view and argues that
the decision about what to call money should be based on which measure of money works best in
helping to predict the movements of key macro variables.
Unfortunately for the empirical approach, experience has shown that different measures may work
better for predicting different variables at any given point in time. For example, the measure that
works best for predicting recessions may not be the measure that works best for predicting exchange
rates. Moreover, the usefulness of any one measure for predicting any one variable tends to vary over
time. What works in one period may not work well in the next.

THE GENERAL EQUILIBRIUM IN MONEY AND PRODUCT MARKET

There can be several equilibrium pairs of Y and r for both money and product market. But there is
single pair of Y and r which emerges from the intersection of IS and LM curves that ensures
equilibrium in both money and product markets.

Equilibrium attained like this is also known as general equilibrium, since it establishes equilibrium in
the money market, bonds market and the product market.

E. Shapiro believes that in case of disequilibrium both the markets adjust simultaneously. Whereas,
William H. Branson is of the opinion that money markets adjust much faster than the product market.
The question how an economy attains general equilibrium can be examined with the help of the figure
below;
Point E shows general equilibrium. All the points left of LM curve take A, L & B indicate that at their
respective levels of income, rates of interest are higher than the rates required to establish equilibrium
in the money market. For instance, at A which has a pair of r0 and Y0, where r0 is too high a rate of
interest to establish equilibrium in the money market.

This is a situation of excess money supply over money demand. Rate of interest must fall to r1 to bring
equilibrium in the money market. But at r1 (I + G) is so high that through multiplier income would
start rising beyond Y0. This rise in Y will increase the transaction demand for money which would be
shifted from speculative demand for money raising the interest rate. This rise in r would reduce the
private business investment, known as crowding out of investment, lowering the income from Y1
level. Ultimately r2, and Y2 levels would settle and both the markets would be in equilibrium at E.

Similarly, at all points beyond IS curve output is more than the aggregate demand I + G. Output will
adjust according to demand. Thus a change in output or income would change the transaction and
speculative demand for money bringing thereby, a change in the rate of interest. These changes will
continue till r2 and Y2 levels are reached establishing equilibrium in money, bond, and product market.

Conclusion, a shift in either IS or LM curve will bring a change in general equilibrium condition and
will settle where the new IS and LM curves are intersecting each other.
References.

Lian, P., & Plott, C. (1998). General Equilibrium, Markets, Macroeconomics and Money in
a Laboratory Experimental Environment. Economic Theory, 12(1), 21-75. Retrieved from
http://www.jstor.org/stable/25055109

L. M. Bhole. (1987). Definition, Measurement and Determination of Money Supply.

Economic and Political Weekly, 22(23), 898-901. Retrieved from
http://www.jstor.org/stable/4377072

Jadhava N. (1994), Monetary Economics for India , Macmillan India, Delhi, 1 st Edition