MONEY SUPPLY

Money supply consists of currency paper money and coins in the hands of the nonbank public
plus demand deposits/checking account balances in commercial banks. This definition of money
as currency plus demand deposits is known as M1. This is the most widely used money supply
concept although economists have defined other measurements of money supply. By formula;
M = m x MB,
Where, M = Money supply, m = Money multiplier MB = Monetary base
The monetary base consists of coins, paper money, and commercial banks’ reserves with the
central bank. The commercial banks’ reserves with the central bank include both the Reserve
Requirement & the Excess Reserves.
In banking, Excess Reserves are bank reserves in excess of the reserve requirement set by a
Central Bank. For commercial banks, Excess Reserves are measured against Standard Reserve
Requirement amounts set by the central bank. These Required Reserve Ratios set the minimum
liquid deposits (such as cash) that must be in reserve at the central bank; more is considered
excess. Hence, MB = C + RR + ER.
Where; C = currency, RR = Required Reserve & ER= Excess Reserves.
Excess Reserves normally do not attract any interest from the central bank. However, the
central bank may give some interest on Excess Reserves in order to discourage commercial
banks from withdrawing them hence controlling the amount of money in circulation.

Measurements of money
Changes in money supply can be related to other changes in the economy such as interest
rates, economic growth & inflation. It is therefore important to know the amount of money in
circulation and appropriately regulate these variables. It is however difficult because one
cannot count all the papers & coins in the economy. The typical method is to use monetary
aggregates and measure the amount of money in the economy with each aggregate using a
slightly different definition. The most common aggregates include; M0, M1, M2 & M3

MONEY COMPONENTS
 AGGREGATES

Mo Currency in circulation (coins and paper money)

M1 Narrow money
 Mo
 Travelers’ cheques
 Demand deposits/checking accounts with no
interest and checkable account with interest

M2 Broad Money
 M1
 Small denomination time deposits
 Savings deposits
 Retail money market mutual funds

M3  M2
 Large denomination time deposit
 Institutional money market mutual funds
 Repurchase agreement

TYPES OF MONEY SUPPLY

Endogenous money supply: This is the money supply that depends on the level of economic
activity influenced by the forces existing within the economy.
Exogenous money supply: It refers to money supply by the central bank irrespective of the
level of economic activity. It is also called autonomous money supply.

Factors That Influence/Determine Money Supply in an Economy

 Level of economic activity: The higher the level of economic activity the higher the
money supply because people will get loans from banks to finance these activities and
the lower the level of economic activity the lower the need for loans hence low money
supply.
 The nature of monetary policy: In case of a tight or restrictive monetary policy, there is
low money supply in an economy while an expansionary monetary policy increases
money supply in an economy.
  The extent of monetization of the economy: Money supply is high when an economy is
highly monetized (has a larger monetary sector) and it is low when there is a large
subsistence sector where money is not used as a medium of exchange.
 The level investment: When the level of investment is high money supply is also high
and the lower the level of investment the lower the level of money supply because high
level of investment increases the flow of money from banks in form of loans.
 The rate of government borrowing: (Financial accommodation) A high rate of
government borrowing from the central bank implies printing more money which
increases money supply but if there is low rate of government borrowing then money
supply will be low.
 Balance of payment position in case: In case of Balance Of Payment surplus, money
supply increases because foreign exchange earnings will he converted into local
currency while for a BOP deficit money supply will reduce because local currency will be
used to close the deficit.
 The level of capital inflow and outflow: Capital inflows say in form of foreign
investments by foreigners increase money supply while capital outflow like profit
repatriation, reduces money supply.
 The level of credit creation by commercial banks: The higher the level of credit creation
the higher the money supply because this increases the amount of money lent by
commercial banks to the public and the lower the credit creation the lower the money
supply.
EQUILIBRIUM SUPPLY & DEMAND FOR MONEY
Demand for money
Demand for money is the desire to hold money in cash form other than any other form of asset.
The key cost and benefit analysis behind the demand for money are;
 Money is costly to hold because of the lost interest that other assets pay.
 It is useful as a means of payment
Wealth & Money
Households and businesses divide their wealth between just two assets;
a) Money (liquid asset): It is useful as a means of payment but does not earn interest

b) Bonds /other assets (illiquid assets): A bond earns interest but is not useful as means of
payment. Wealth = Bond holdings + Money holdings
Properties of individual money demand
• Money demand is increasing in price level. I.e. as the price level increases money demand
increases too.
• It is increasing in real income. When real income increases, money demand increases too.
• It is decreasing in nominal interest rate (interest on other assets-the opportunity cost of
holding money)
Aggregate money demand: This is the sum of money demand for all individuals in the
economy.
Properties of aggregate money demand
 It is increasing in real GDP. As real GDP increases, aggregate demand increases.
 Aggregate money demand is increasing in general price level.
 It is decreasing in market nominal interest rates.

 The aggregate money demand curve

Interest The money demand curve is drawn

rate for a given GDP and a given price level

6%

Md

100 Money (Billion in Shs)

The aggregate money demand represents the total quantity of money demand for each
nominal interest rate.

Movements along the money demand curve

Movements along the money demand curve either upwards to the left or downwards to the
right is accelerated by change in the level of nominal interest rates.

Interest Increase in interest rates/mov’t upwards to the

left

6%
Fall in interest rate/ mov’t downwards
to the right.
Md
100 Money (Billion in Shs)

A shift in the money demand curve

This can be explained by;
 A change in real income/ real GDP
 A change in price/ general price level

Interest rate The money demand curve shifts outwards if the price

Level increases or if real income increases

Md1

Mdo

Money (billion Shs)

Money Supply & Money Market Equilibrium
Money supply refers to the amount of money in hands of the public plus money on demand
deposits/ checkable accounts. Money supply (M) = money multiplier (m) X the monetary base
(MB).
Aggregate Money Supply Curve
This represents the total quantity of money supply in the economy for each level of interest
rates.
The money supply curve is parallel to the y-axis and this implies that money supply is
autonomous.

Interest rate MS

6%

3%

100 Money (billion Shs)

Shifts in Money Supply Curve

The money supply curve can either shift outwards to the right or inward to the left.

1. Rightward shift in money supply curve: This is known as the monetary expansion. It
leads to an increase in money supply from L 0 to L2 in the figure below within the
economy. For example, open market purchases of bonds by the central bank. The
rightward shift is represented by shift of the money supply from MS 0 to MS2. This leads
to a fall in the level of equilibrium interest rates from r 0 to r2 .
2. Leftward shift in the money supply curve: This is called monetary contraction. It leads
to a fall or decline in money supply from L 0 to L1. The leftward shift is represented by
shift of the money supply curve from MS0 to MS1. This leads to an increase in the level of
interest from r0 to r1.
Interest rate
 MS1 MS0 MS2

r1

ro

r2 Md

L1 LO L2 Money (billion Shs)

The money market is in equilibrium when the quantity of real balances demanded equals the
quantity of money supplied.

Interest MS

rate

Md

Money (billion Shs)

Equilibrium is represented by point E where the money supply curve intersects money demand
curve. The figure above shows the demand curve M d for real money balances for a given level
of real income. The higher the interest rate and the opportunity cost of holding money, the
lower the quantity of real money balances demanded. With a given price level, the Central Bank
controls the quantity of nominal money and real money. The supply curve is vertical at this

quantity of real money L0. Equilibrium is at point E at the interest rate r0 and quantity of real

money people that people wish to hold at this point just equals the outstanding stock L0.