“Impact of Macroeconomic Parameters on Money

Supply”

Master in Management Studies (M.M.S)

(Two Years Full-time) Degree Course

ROLL NO. : 20-S-088

Under the Guidance of

Dr. Chandrahauns Chavan

University of Mumbai
Jamnalal Bajaj Institute of Management Studies
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I, the undersigned Mr. Nayan Pakhale Roll No. 20-S-088 studying in the Second Year of
Master in Management Studies (M.M.S) (Two Years Full-time) Degree Course is doing my
project work under the guidance of Dr. Chandrahauns Chavan, wish to state that I have
interacted my guide on the dates mentioned below for project guidance:

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Place: Mumbai
 Project Submission Form

This is to certify that Mr. Nayan Pakhale of the Master in Management Studies (M.M.S)
two-year full-time degree course has carried out the work on the following project under my
guidance:
Project Title

Impact of Macroeconomic Parameters on Money Supply

Date: Signature and Name of the Guide

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 Acknowledgement

This report is a culmination of my efforts during fourth semester of Master

of Management Studies course at JBIMS, Mumbai. This project has been a great
learning experience for me and I have been ably guided and supported in my
endeavour by many people.

I would like to extend my heart-felt gratitude to my guide for his support

and help during the course of the entire period. This project would not have been
possible without his guidance. I really appreciate his effort while helping me to
make this project report which I believe has enhanced my knowledge by applying
the skills on the topic I had chosen. I gratefully thank The Director, JBIMS for giving
me an opportunity to undertake such a useful thesis. I am also thankful to the
respectable faculty members at JBIMS for their teachings and thorough concept
building in various managerial disciplines which helped a lot during the course of
this project.

2 Impact of Macroeconomic Parameters On Money Supply

 TABLE OF CONTENTS

Sr.No. Particulars Page No.

1 Introduction 6

2 Overview of Literature 8

3 Scope and Objectives 10

4 Types of money 12

5 Components of money supply 14

6 Impacts of inflation 19

7 Effect of GDP on Money Supply 21

8 Effect of inflation on monetary transmission 23

9 Shift in the Money Market due to Inflation 27

10 Effect of plastic cards on money supply 29

11 Effect of interest rates on Money supply 31

12 Correlation Analysis 33

13 Conclusion 36

References 37

3 Impact of Macroeconomic Parameters On Money Supply

 LIST OF FIGURES

Sr. No. Particulars Page No.

Figure 5.1 Money supply distribution 14

Figure 5.2 Money supply M3 YoY 16

Figure 7.1 Broad Money (% of GDP) 22

Figure 8.1 Market interest rates 25

Figure 9.1 Shift in supply curve 27

Figure 9.2 Shift in demand curve 28

Figure 11.1 Interest Rates YoY 32

LIST OF TABLES

Sr. No. Particulars Page No.

Table 1.1 CPI index of India 7

Table 5.1 Money and credit 18

Table 6.1 Other price indexes 20

Table 12.1 Symbols of Correlation analysis 33

Table 12.2 Correlation Analysis 34

4 Impact of Macroeconomic Parameters On Money Supply

 ABSTRACT

Through this project work we would like to assess the impact of

macroeconomic factors on money supply. The various factors that influence
the circulation of money in a macroeconomic environment have been dealt
with in this case through simple statistical tools like Microsoft Excel and
SPSS 13.0.

The factors considered herein are GDP, Inflation rate, foreign

exchange reserves, gold prices and many others. As future managers we
would like to get an insight into what factors influences the supply of money
in an economy. Through this project I have attempted to link the theoretical
concepts garnered from the classes conducted by our faculty to the real life
situation by taking data from real sources. By studying the practical situation
and linking it with the theory I am trying to make an attempt to conceptualize
the learning gathered so far.

5 Impact of Macroeconomic Parameters On Money Supply

 1. INTRODUCTION

Inflation and monetary policy are closely related concepts wherein the
latter can be used efficiently to reduce the effect of the former. Inflation is
the rise in prices and wages that reduces the purchasing power of money.
Monetary policy is the regulation adopted by the central bank, which
stabilizes the prices and maximizes production and employment of the
country.

Monetary policy is a regulation of a central bank which controls size

and growth rate of the money supply. Monetary policy directly influences the
interest rates which in turn has a negative relation with the price level. In the
face of inflation the central bank of the country generally resorts to a rise in
the cash reserve ratio, repo rate and reverse repo rate. The basic idea is to
reduce the money supply in the economy. This would reduce aggregate
demand. This reduction would again help reduce the price level. Monetary
policy is adopted with an objective to make the most of production and
employment and consequently stabilize the price level of a country.
Monetary policy also regulates the interest rate, availability of credit and at
the same time promotes the overall economic growth of a country.

Inflation occurs when the general level of prices is increasing. Today

we calculate inflation by using price indexes-weighted averages of the prices
of thousands of individual products. The CPI measures the cost of a market
basket of consumer goods and services relative to the cost of that bundle
during a particular base year. The GDP deflator is the price of GDP. In India,
inflation is measured through CPI (effectively from 1 April 2014). The recent
CPI Index of Indian inflation is given below:-

6 Impact of Macroeconomic Parameters On Money Supply

Table 1.1:

*Source: https://www.rbi.org.in/scripts/AnnualReportPublications.aspx?year=2018

7 Impact of Macroeconomic Parameters On Money Supply

 2. OVERVIEW OF LITERATURE

There exists vast literature on the association between

macroeconomic variables and money supply. Although results are mixed,
most studies have shown evidence that there are significant relationships
between macroeconomic variables and supply. An early paper that opened
up avenues for research in this regard was by Klaeffling, M., & Lopez Perez,
V, in “Inflation targets and the liquidity trap”, which explains how inflation
targeting affects money supply in the economy. Woodford, M. (2003), in his
paper “Interest and prices: Foundations of a theory of monetary policy”
concludes that monetary policy have indirect impact on prices. Ihsan and
Anjum has examined the impact of money supply (M2) on the GDP of
Pakistan, due to high rate of inflation has adversely affected the economy of
Pakistan which is a result of excessive supply of money (M2) by SPB. They
have taken into consideration the data for 12 years from 2000 to 2011, and
analyzed this data by using the regression model. Bednarik (2010) and
Granger-Causality test to analyse the relationship between money supply
(M3) and real GDP in the Czech Republic, by using quarterly data over
period between 2002 to 2009, and conclude that whether the quantitative
theory of money holds in Czech Republic, there is indeed strong and mutual
relationship between money supply and real GDP.

It is well established in the financial economics literature that the

macroeconomic variables affect the behavior of money supply (Chen, Roll
and Ross, 1986). Apart from the fundamentals of the firm, macro
environment plays an important role in determining the money supply. The
behavior of macroeconomic variables, both internal and external, has
positive as well as the negative effect on the money supply depending on
the nature of the variables. It has also been established that
8 Impact of Macroeconomic Parameters On Money Supply
stock markets of developed and developing countries may respond
differently from the macroeconomic variables (Atlay, 2003). Studies have
also highlighted that generally three to five factors are extracted to explain
the behavior of macroeconomic relationship (Roll & Ross, 1980; Chen,
1983)

Some of the studies have considered only the real economic variables
(Fama, 1981); and others have used financial variables to emphasize the
effect on money supply volatility (Connor & Korajczyk, 1986). There are
more comprehensive studies that have used the combination of real and
financial variables (Van Rensburg, 2000; Solnik 1987,). Besides, more
selective studies have been done to explain the changes in the money
supply. As Fex and oil prices are more important variables in the crude
producing countries. These two factors were able to explain considerably
the variation in the money supply in the Iranian economy (Mohseni, 2007).

9 Impact of Macroeconomic Parameters On Money Supply

 3. SCOPE AND OBJECTIVES

Money supply in any economy has considerable effect on the other

macroeconomic variables depending on the strength of money multiplier;
hence it has been included in the analysis represented by broad money
supply measure (M3). Consumer price index is a reflection of inflation in the
economy and its high level may threaten the macroeconomic stability and
thus has an impact on money supply. Therefore, consumer price index has
been included in the study as a macroeconomic variable. In the trading
economies, exchange rate has a great influence on the flow of money in the
economy. India is dependent on other nations for more than three fourth of
their crude oil need. Any movement in the international crude prices
considerably affects the national economy and ultimately reflected in the
flow of money of the country. Gold Price is included in the study as a
variable to examine whether gold price embodies any additional significant
relation with share market movements. Since, gold has an asset value; it
works as an important saving material. The strength and stability of the host
country’s currency is measured by the level and the volatility of the call
money rates. The technology transfer in terms of innovations and invention
to developing country like India in terms of FDI and FII has an impact on the
money supply. The potential of the economy is strengthened by the foreign
exchange reserves which has some impact on the economy performance.
Repo rate opted by the RBI as a monetary management instrument do
provide stimulus or disincentive to market in terms of their investment
decisions, obviously it is reflected in the movement of the stock market. The
industrial growth rates provide more confidence in the economy hence more
faith in the broad money. Surplus Balance of trade grant strengthen the
economy in the international arena and help to generate surplus

10 Impact of Macroeconomic Parameters On Money Supply

funds to import important needs of the economy, therefore, confidence in
the economy improves and ultimately reflected in the flow of money, Thus,
BOT has been included as a variable in the analysis.

The objective of this paper is to find the influence of macroeconomic

variables on the money supply of the economy and also find correlation
between them.

11 Impact of Macroeconomic Parameters On Money Supply

 4. TYPES OF MONEY

Commodity money: Money as a medium of exchange first came into human

history in the form of commodities. A great variety of items have served as
money at one time or other-cattle, olive oil, beer or wine, copper, iron, gold,
silver, diamonds etc. By the eighteenth century commodity money was
almost exclusively limited to metals like silver and gold. These forms of
money had intrinsic value, meaning that they had use value in themselves.
Because money had intrinsic value, there was no need for the government
to guarantee its value, and the quantity of money was regulated by the
market through the supply and demand for gold or silver. The advent of
monetary control had led to a much more stable currency system. The
intrinsic value of money is now the least important thing about it.

Fiat Money: The word fiat means the “command of the sovereign”. Fiat
currency is the kind of money which doesn’t have any intrinsic value and it
can’t convert into a valuable resource. The value of fiat money is
determined by government order which makes it a legal instrument for all
transaction purposes. The fiat money needs to be controlled as it may affect
entire economy of a country if it is misused. Today Fiat money is the basis
of all the modern money system. The real value of fiat money is determined
by the market forces of demand and supply.

Fiduciary Money: Today’s monetary system is highly fiduciary. Whenever

any bank assures the customers to pay in different types of money and
when the customer can sell the promise or transfer it to somebody else, it is
called the fiduciary money. Fiduciary money is generally paid in gold, silver
or paper money. There are cheques and banknotes, which are the
examples of fiduciary money

12 Impact of Macroeconomic Parameters On Money Supply

because both are some kind of token which are used as money and carry
the same value

Commercial Bank Money: Commercial Bank money or demand deposits are

claims against financial institutions that can be used for the purchase of
goods and services. A demand deposit account is an account from which
funds can be withdrawn at any time by cheque or cash withdrawal without
giving the bank or financial institution any prior notice. Banks have the legal
obligation to return funds held in demand deposits immediately upon
demand (or ‘at call’). Demand deposit withdrawals can be performed in
person, via cheques or bank drafts, using automatic teller machines
(ATMs), or through online banking.

13 Impact of Macroeconomic Parameters On Money Supply

 5. COMPONENTS OF MONEY SUPPLY

Money supply is the total stock of money circulating in an economy. In

general terms, it is also called broad money. In the simplest language,
Reserve Money is Currency in Circulation plus Deposits in Commercial
Banks.

Money supply consists of:

total currency circulating in the public plus

The non-bank deposits with commercial bank.

Money supply includes deposits generated in the banking system resulting

from a multiplier effect of movement of currency in the banking system as
well as other forms of liquid assets.

Figure : 5.1

Standard Measures of Money Supply

Central bank money (M0)- obligations of a central bank, including currency

and central bank depository accounts.

14 Impact of Macroeconomic Parameters On Money Supply

Commercial bank money (M1-M3) – obligations of commercial banks,
including current accounts and savings accounts.

In the money supply statistics, central bank money is M0 while the

commercial bank money is divided up into the M1-M3 components.

Generally, the types of commercial bank money that tend to be valued at

lower amounts are classified in the narrow category of M1 while the
types of commercial bank money that tend to exist in larger amounts are
categorized in M2 and M3, with M3 having the largest.

Reserve Money (M0):

= Currency in circulation + Bankers’ deposits with the RBI +

‘Other’ deposits with the RBI

= Net RBI credit to the Government + RBI credit to the commercial sector +
RBI’s claims on banks + RBI’s net foreign assets + Government’s
currency liabilities to the public – RBI’s net non-monetary liabilities.

M1:

=Currency with the public + Deposit money of the public (Demand deposits
with the banking system + ‘Other’ deposits with the RBI).

M2:

=M1 + Savings deposits with Post office savings banks.

15 Impact of Macroeconomic Parameters On Money Supply

M3: (Broad concept of money supply)

= M1+ Time deposits with the banking system

= Net bank credit to the Government + Bank credit to the commercial sector
+ Net foreign exchange assets of the banking sector + Government’s
currency liabilities to the public – Net non-monetary liabilities of the banking
sector (Other than Time Deposits).

Figure 5.2:

Source: RBI Data

M4:

=M3 + All deposits with post office savings banks (excluding National
Savings Certificates).

16 Impact of Macroeconomic Parameters On Money Supply

Money Multiplier (m):

The money multiplier is an approach used to demonstrate the maximum

amount of broad money that could be created by commercial banks for a
given fixed amount of base money and reserve ratio.

The money multiplier, m, is the inverse of the reserve requirement, R: For

example, with the reserve ratio of 20 percent, m can also be expressed as
a fraction:

This number is multiplied by the amount of reserves to estimate the

maximum potential amount of the money supply. For example, from Rs.100
can be multiplied by 5 to generate Rs.500 money supply if Reserve Ratio is
1/5 (20%) or when Money Multiplier is 5. When Reserve Ratio is 1/4 (25%)
or when Money Multiplier is 4, that would generate only Rs. 400 as money
supply.

17 Impact of Macroeconomic Parameters On Money Supply

Table: 5.1

18 Impact of Macroeconomic Parameters On Money Supply

 6. IMPACTS OF INFLATION

Inflation affects the real economy in two specific areas: it can harm
economic efficiency, and it can affect total output. We begin with the
efficiency impacts:

Inflation impairs economic efficiency because it distorts prices and

price signals. In a low inflation economy, if the market price of a good rises,
both buyers and sellers know that there has been an actual change in
supply and/or demand conditions for that good, and they can react
appropriately. By contrast in a high inflation economy, it’s much harder to
distinguish between changes in relative prices and changes in the overall
price level.

Inflation also distorts the use of money. Currency is money that bears a
zero nominal interest rate. If the if the inflation rate rises from 0 to 10%
annually, the real interest rate on currency falls from 0 to -10% per year.
There is no way to correct this distortion. As a result of the negative real
interest rate on money, people devote real resources to reducing their
money holdings during inflationary times. They go to the bank more often.
Corporations set up elaborate cash management schemes. Real resources
are thereby consumed simply to adapt to a changing monetary yardstick
rather than to make productive investments. The other price indices for
Inflation rate Y-o-Y basis for India:-

19 Impact of Macroeconomic Parameters On Money Supply

Table: 6.1

Source:
https://rbidocs.rbi.org.in/rdocs/AnnualReport/PDFs/APPEN201718_49B73DE2B8
0614A8 896347721554585B5.PDF

20 Impact of Macroeconomic Parameters On Money Supply

 7. EFFECT OF GDP ON MONEY SUPPLY

Money supply and GDP do not automatically affect each other, but Money
Supply can affect GDP depending on monetary policy; the expressed
intention in economic management is to monitor the money supply to
allow transactions to take place. Therefore, if money supply is severely
restricted it is likely to affect the GDP: i.e.: reduce the volume of
transactions. The GDP can only increase the demand of money and
transactions will stall if that demand is not met.
GDP is also inadequate as a measure of real production, because it
does not truly represent production, but it is a statistic of dollar value of all
transactions that have taken place. A comparison of the two statistics
maybe valuable after the fact to examine the difference in growth ratio, to
maybe predict near term inflation, if money growth was too much larger than
GDP.

Money is NOT increased as a result of greater ability to produce,

but it is increased intentionally to attempt to allow the greater ability
potential to materialize. Money supply affects GDP by making transactions
more efficient. You don't need to find someone to trade with to get what you
want, everyone takes money. The more of it there is, the larger this effect
becomes. GDP affects money supply through the banking system. When
growth is high, banks make additional loans and expand the money supply.
The Federal Reserve also has something to do with it, but the dynamic
aspects of money supply rest with the banking sector.

21 Impact of Macroeconomic Parameters On Money Supply

Figure 7.1

Broad money (% of GDP)

Source:
https://data.worldbank.org/indicator/FM.LBL.BMNY.GD.ZS?end=2017&locations=
IN&sta rt=1960&view=chart

22 Impact of Macroeconomic Parameters On Money Supply

 8. EFFECT OF INFLATION ON MONETARY TRANSMISSION

Having examined the building blocks of money, we now describe the monetary
transmission mechanism, the route by which changes in the supply of money
are translated into changes in output, employment, prices and inflation. The
Reserve Bank is concerned about inflation and has decided to slow down the
economy. There are five steps in the process:-

1. To start the process, the Reserve Bank takes steps to reduce bank
reserves. Reserve Bank reduces bank reserves primarily by selling
government securities in the open market. This open market operation
changes the balance sheet of the banking system by reducing total bank
reserves.

2. Each dollar reduction in bank reserves produces a multiple contraction in

checking deposits, thereby reducing the money supply. Since the money
supply equals currency plus checking deposits, the reduction in checking
deposits reduces the money supply.

3. The reduction in the money supply increases interest rates and tightens
credit conditions. With an unchanged demand for money, a reduced supply
of money will raise interest rates. In addition the amount of credit (loans and
borrowing) available to people will decline. Interest rates will rise for
mortgage borrowers and for businesses that want to build factories, buy
new equipment, or add to inventories. Higher interest rates tend to reduce
asset prices (such as those of stocks, bonds, houses) and therefore
depress the values of peoples’ assets.

4. With higher interest rates and lower wealth, interest sensitive spending-
especially investment, tends to fall. The combination of higher interest rates,

23 Impact of Macroeconomic Parameters On Money Supply

tighter credit and lower wealth tends to reduce investment and consumption
spending. Businesses will scale down their investment plans, as will state
and local governments. For example, higher interest rates may lead airlines
to stretch out their purchases of new aircraft. Similarly consumers may
decide to but a smaller house, or to renovate their existing one, when rising
mortgage interest rates increase monthly payments relative to monthly
income. In an economy increasingly open to international trade, higher
interest rates may raise the foreign exchange rate depressing net exports.
Hence, tight money will raise interest rates and reduce spending on interest
sensitive components of aggregate demand.

5. Finally, the pressures of tight money, by reducing aggregate demand,

will reduce income, output, jobs and inflation. The aggregate supply and
demand analysis shows how a drop in investment and other autonomous
spending may depress output and employment sharply. Furthermore, as
output and employment fall below the levels that would otherwise occur,
prices tend to rise less rapidly or even to fall. Inflationary forces subside.

The supply of and demand for money: One major step in the transmission
mechanism is the response of interest rates and credit conditions to
changes in the supply of money. The demand for money depends primarily
on the need to undertake transactions. Households, businesses and
governments hold money so that they may buy goods, services and other
items. In addition, some part of the demand for money derives from the
need for a safe and highly liquid asset.

The supply of money is jointly determined by the private banking system

and the nation’s central bank. The central bank, through open market
operations and other instruments, provides reserves to the banking system.

24 Impact of Macroeconomic Parameters On Money Supply

Commercial banks then create deposits out of the central bank reserves. By
manipulating reserves, the central bank can determine the money supply within
a narrow margin of error.

The supply and demand for money jointly determine the market interest
rates. The following figure shows the total quantity of money M on the
horizontal axis and the nominal interest rate i on the vertical axis. The
supply curve is drawn as a vertical line on the assumption that the Central
Bank keeps the money supply constant at M*. In addition we show the
money demand schedule as a downward sloping curve because the
holdings of money decline as interest rates rise during inflation. At higher
interest rates, people and businesses shift more of their funds to higher
yield assets.

Figure: 8.1

The intersection of the supply and demand schedules in the figure

determines the market interest rate. Interest rates are the prices paid for the
use of money. In the figure, the equilibrium interest rate at the point of

25 Impact of Macroeconomic Parameters On Money Supply

intersection of supply and demand. Only at this point is the level of the
money supply that the Central Bank has targeted consistent with the
desired money holdings of the public. During inflation, at a higher interest
rate, there would be excessive money balances. People would get rid of
their excessive money holdings by buying bonds and other financial
instruments, thereby lowering market interest rates towards the equilibrium
rate.

26 Impact of Macroeconomic Parameters On Money Supply

 9. SHIFT IN THE MONEY MARKET DUE TO INFLATION

To understand the monetary transmission mechanism, we need to see how

changes in the money market due to Inflation affect interest rates. The
Central Bank becomes worried about Inflation and tightens monetary policy
by selling securities and reducing the money supply. The impact of a
monetary tightening is shown in the following figure. The leftward shift of the
money supply schedule means that market interest rates must rise to
induce people to swap their money for bonds and other non-monetary
assets. The gap between E and N shows the extent of excess demand for
money at the old interest rate. Interest rates rise until the new equilibrium is
attained shown at point E’, with a new and higher interest rate.

Figure: 9.1

27 Impact of Macroeconomic Parameters On Money Supply

There are also frequent shocks to money demand due to cost push
Inflation. With higher prices the demand for money would increase, shifting
the money demand curve to the right from DD to D’D’ as shown in the
following figure and leading to an increase in equilibrium interest rates.

Figure 9.2

The money market is affected by a combination of the public’s desire to hold

money (represented by demand-for-money DD curve) and the Central
Bank’s monetary policy (which is shown as a fixed money supply SS). Their
interaction determines the market interest rate, i. During Inflation a
restrictive monetary policy shifts the SS curve to the left, raising market
interest rates. Likewise due to Inflation an increase in the cost of goods and
services shifts the DD curve to the right and raises interest rates.

28 Impact of Macroeconomic Parameters On Money Supply

 10. EFFECT OF PLASTIC CARDS ON MONEY SUPPLY

In recent years, electronic payment instruments such as credit cards, debit

cards and prepaid instruments in banking transactions have attracted
attention of academicians as well as regulators. It is because of mainly two
reasons: (i) there is a high potential that the electronic payment instruments
can substitute cash and can affect the amount of currency that a central
bank should keep in circulation.
(ii) If so, that would affect independence of monetary authority since a
decreasing amount of currency in circulation would lead to a reduction in
seigniorage, the revenue that a central bank earns from having a complete
control over issuing currency notes in the country. As a result, central banks
may be forced to rely on financial support of governments for their
operational needs, and hence, that affects independence of their monetary
policy decisions

Study by Akhand and Milbourne (1986) first included cards as an

alternative payment media in money demand framework and found that
cards motivate people to hold less in money balances. After that focused
study on this topic was mainly on two questions: will increased use of credit
and debit cards lead to wither of cash and what would be the impact of such
a change on monetary policy? In one of the study, it is found that the
average cost of card payment is 1.3 percent of transaction value, which is
much lower than the cost of cash payment at 9 per cent of transaction
value.

On the effects of cards usage on the economy, Zandi and Singh

found that 1 per cent raise in card usage increased consumption by 0.039
per cent and GDP by

29 Impact of Macroeconomic Parameters On Money Supply

0.024 per cent. The increase was little high in developed countries
compared to developing countries. For India, it was 0.05 per cent and 0.004
percent, respectively. Also it is found that electronic money can change the
money demand function and reduce the average amount of cash held which
would increase circulation of money in the economy, thereby positively
affecting velocity of money.

The fact is that credit cards always come with interest free credit for
customers, while owning credit cards customers do less cash transactions
and prefer less cash to be held in hand. Result on the impact of debit card is
interesting as it is found debit cards usage is positively associated with
currency demand. This is because debit cards increases marginal utility of
money and increase demand for currency. These cards are majorly used for
cash withdrawals to make payments in cash since banking penetration is
less in the country and thus acceptability of debits cards by merchants is
also limited. Significant portion of population in India do not have bank
accounts, do not have access to electronic cards as such and rely on cash
for their economic transactions.

30 Impact of Macroeconomic Parameters On Money Supply

 11. EFFECT OF INTEREST RATES ON MONEY SUPPLY

If the central bank wants to reduce interest rates, it will offer to lend
reserves to banks at less than the other banks are charging. This increases
narrow money and reduces the demand for borrowing reserves, meaning
other banks have to reduce the interest they charge on the reserves they
wish to lend. On the other hand, if the central bank wants to increase
interest rates then it will offer to borrow reserves from banks wishing to lend,
at rates higher than other banks are willing to pay. This reduces the narrow
money supply and forces banks wishing to borrow to pay higher interest
rates.

When banks create deposits by extending loans, the borrowers

usually spend the money straight away. Banks rely on the payments they
receive from other banks on behalf of their depositors to provide the
reserves needed to settle the payments their depositors wish to make. If
these receipts are not enough to cover the payments that borrowers wish to
make out of their new money then banks have to resort to the money
market to borrow the shortfall, and they will ensure that the interest they
charge the borrower will include the cost of borrowing the extra reserves. So
if the money market interest rates have increased, the banks will increase
their lending rates also and this might discourage would-be borrowers, who
can no longer justify the cost of the loan, and also encourage existing
borrowers to repay loans more quickly to avoid paying the additional
interest. This has the effect of reducing the rate of growth, and possibly also
the level, of the broad money supply. Likewise, a reduction in the money
market rates will tend to lead to an increase in the rate of growth of the
broad money supply.

31 Impact of Macroeconomic Parameters On Money Supply

Figure: 11.1

Interest Rates YoY

32 Impact of Macroeconomic Parameters On Money Supply

 12. CORRELATION ANALYSIS

The analysis covers the period from January 2001 to March 2018.
This period witnessed the phases of boom as well as recession, hence may
better reflect the relationship between Money supply (M3) and other
macroeconomic variables. The monthly average data of below
macroeconomic variables are taken from various websites presented in the
below table. The selected variables from different segments of the economy
are used which have potential to influence the circulation of money supply
in the economy or have indirect impact on the money supply.

Table: 12.1

Unit of
Symbol Variable measurement
M3 Money Supply Rs. Billions
CPI Consumer Price Index Index
GP Gold Prices Per Troy Ounce
COP Crude Oil Prices $ Per Barrel
FER Foreign Exchange Reserves Rs. Billions
FDI Foreign Direct Investment USD Millions
FII Foreign Institutional Investment Rs. Crores
CMR Call Money Rate Percentage
BOT Balance of Trade Rs. Billions
ER Foreign Exchange Rate Rs. vs. $
REPO Repo Rate Policy Rate
IGR Industrial Growth Rate Percentage

33 Impact of Macroeconomic Parameters On Money Supply

 Since this analysis is related to impact of various macroeconomic
variables on the money supply in India. Variables identified to include as
macroeconomic variables in the analysis are expected to be correlated
among themselves. This has further been indicated by the correlation matrix
below:

Table 12.2:

Variabl M3 CPI GP CO FER FDI FII CM BO ER Rep IGR

e P R T o
- -
M3 1 0.99 0.98 0.85 0.93 0.57 0.54 0.4 0.92 0.46 -0.08 0.25

- -
CPI 1 0.98 0.83 0.91 0.54 0.54 0.41 0.92 0.49 -0.07 0.25
- -
GP 1 0.82 0.88 0.52 0.49 0.48 0.92 0.54 0.01 0.31
-
COP 1 0.89 0.64 0.46 0.46 0.81 0.07 0.04 0.07
- -
FER 1 0.68 0.52 0.29 0.86 0.25 -0.17 0.12
-
FDI 1 0.25 0.27 0.54 0.02 -0.07 0.04
-
FII 1 0.06 0.53 0.11 -0.17 0.03
- -
CMR 1 0.45 0.25 0.75 0.13
BOT 1 0.49 -0.06 0.23
-
ER 1 0.16 0.72
-
Repo 1 0.06

IGR 1

(* output using SPSS software)

*Source:
www.rbi.org.in,www.tradingeconomics.com,www.tradingeconomics.com,ww
w.X-
rates.com,www.indexmundi.com,www.tradingeconomics.com,www.tradingeconomics.com,
www.tradingeconomics.com,www.allbankingsolutions.com, www.tradingeconomics.com,
www.X- rates.com, www.allbankingsolutions.com, www.tradingeconomics.com
34 Impact of Macroeconomic Parameters On Money Supply
 . The above table provides some inkling towards the strong
correlation among many of the variables. The correlation matrix provides an
introspective view regarding the inter relationship among the variables. The
cells keeping bold values explain strong correlation.

As it is seen that the money supply has strong correlation with

consumer price inflation, gold prices and foreign exchange reserves, these
variables has a significant impact on flow of money supply in the economy.
Also, from the correlation matrix, it is observed that balance of trade has a
negative correlation with the M3.

35 Impact of Macroeconomic Parameters On Money Supply

 13. CONCLUSION

The money supply is ultimately determined by the policies of the

Central Bank. By setting reserve requirements and the discount rate, and
especially by undertaking open market operations, the Central Bank
determines the level of reserves, the money supply and short term interest
rates based on the Inflation rate and the GDP figures. Inflation rates and
GDP figures have a direct impact on the money supply since their increase
and decrease determines the level of circulating money in the system as
and when required by the Central Bank.

Also, considering the impact of plastic cards, With the kind of

changes expected to be in banking near future, for instance measures such
as financial inclusion to provide banking services to all unbanked and
marginal sections of population, would bring new payment channels and
increase penetration in use of financial services which would lead to less
use of cash and thus reduce demand for currency. Banks and the public are
cooperating partners in this process. Banks create money by multiple
expansions of reserves and the public agrees to hold money in depository
institutions.

By correlation analysis, it can be concluded that foreign exchange

reserves, gold prices, crude oil prices, FDI & FII also has a significant
impact on the changes in money supply observed over a period of 18 years
in this project work. The correlation values are highly significant in
explaining the relationship between the macroeconomic variables and
money supply.

36 Impact of Macroeconomic Parameters On Money Supply

 REFERENCES

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Attanasio, O., Jappelli, T. & Guiso, L. (2002). The demand for money,
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Frank Shostak, "Commodity Prices and Inflation: What’s the
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Hummel, Jeffrey Rogers. "Death and Taxes, Including Inflation: the
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Kiley, Michael J. (2008), "Estimating the common trend rate of inflation
for consumer prices and consumer prices excluding food and energy
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Michael F. Bryan, "On the Origin and Evolution of the Word ’Inflation"
Mark Blaug, "Economic Theory in Retrospect", pg. 129: "...this was the
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37 Impact of Macroeconomic Parameters On Money Supply

 Zandi, M. & Singh, V. (2010). The Impact of Electronic Payments on
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Webliography:

Finance and Economic Discussion Series (Federal Reserve

Board), http://www.federalreserve.gov/Pubs/feds/
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www.investopedia.com
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38 Impact of Macroeconomic Parameters On Money Supply