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1. Learning Outcomes
After studying this module, you shall be able to

· Know the proximate determinants of the money multiplier

· Learn about the effects ofchanges in each of these determinants on the money multiplier
· Identify the ultimate determinants of the proximate determinants
· Evaluatethe impact of these determinants on the money supply.
· Analysethe behavior of the proximate and ultimate determinants of the money multiplier
in India

2. Introduction

Determinants of the money multiplier

The behavioural relation of the Money Supply equation as discussed in the previous modules was

M=m(c,r,t)H

Where M =Ordinary Money

H = High Powered Money

c = C/DD ,t = TD/DD and r = R/D ratios .

This relationship is not linear or log linear, the particular structure of the model in ratios ,as
derived from the equilibrium relation becomes important for our study.

Here the currency/demand deposits ratio( c )Time Deposit/Demand deposit ratio ( t ) are
representative of the non bank public ‘s portfolio decisions and are their behavioural ratios, while
the reserve ratio ( r) where(r = r r +e )is largely determined by the central bank through the
statutory cash reserve requirement (r r ) and residually by the commercial banks excess reserve
ratio ( e ) where e = ER/D.Thus ,r represents in part, the banks portfolio decision.

The money multiplier Theory thus decomposes all changes in the Money Supply M into two
broad heads

1) changes in m
2) changes in H

If changes in M are, to a large extent , due to changes in H,then it provides support to the
money multiplier theory

The system however, is multilayered ,for , in reality,

m = f [ c ( ) ,t ( ) ,r ( ) ]

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That is ,the proximate determinants of m and therefore of

money supply are further affected by the ultimate determinants
like several rates of interest,holdings of black money,spread of banking facilities,e.t.c which
impinge on one or more of the asset ratios.These proximate determinants serve as intermediate
stages through which the money supply mechanism works,and they also provide highly useful
vantage points from which to observe and analyse the working of the complex myriad of forces
that impinge on the behavior of the money multiplier.

This two fold classification has policy implications too.It tells us what variables should be
manipulated to change H and hence M –(m being a behaviorally determined variable).If there is a
change in the currency/demand deposit ratio( c ) there is no guarantee that there will not be
offsetting movements in the time deposit/demand deposit ratio( t) and the reserve ratio( r).The
number of decisionmakers involved being very large,it may be difficult topredict the values of c ,t
,r unless an empirical analysis of the three ratios is done.The empirical analysis can be conducted
at two levels

a)at the macro level where it is seen that c, t, r have been highly stable implying that changes in c,
t,r have gone in offsetting directions giving it a long run stability.Thus most changesin money
supply are attributed to changes in H.

b) at an analytical level,the money supply equation can be used to explain the observed behavior
and to predict future behavior on the basis of the observed behaviour.We can also analyse the
variables to be manipulated to bring about changes in money supply

3.-The analytical framework

3.1 Effect of a change in c, t, r, on the money multiplier m

This can be calculated by differentiating the narrow money multiplier

m1 = 1 + c/[c +r (1 +t )]-1 with respect to each of the three ratios c,r ,t yielding the
following

(i)del m1 = -[1-r ( 1 + t )]<0 for r(1+t ) <1

del c [c + r ( 1 +t )]2

(ii) del m1= - r (1+ c ) < 0 that is,as t increases m1 decreases and hence

del t [c + r (1 + t ) ]2 M1 also decreases

However since M3 = M1 + TD,an increase in t would imply an increase in

M3.Therefore the initial definition of money supply adopted in the analysis is
important.

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(iii)del m1 =-[(1 + t ) ( 1 + c)]<0

del r [c + r (1 + t )]2

It can be seen that increases in r ,t,will unambiguously lower the value of m1 while
increases in c will lower m1 so long as r( 1 +t )<1,representing leakage of H into currency
holdings or reserves.

However ,it is important to note that since the total reserve ratio( r) is equal to the
statutory reserve ratio ( r r) plus the excess reserve ratio( e) ,a change in r could come
about through changes in rr or e.It is possible for the impact ofchanges in r r to be picked
up through an adjustment in H or m.If the impact of changes in r r are captured in m ,it
becomes behaviourallyunstable.It may be better therefore to capture the changes in the
statutory reserve ratio r r by adjusting the High powered Money H* making it a policy
amenable variable and m* =M/H* a behaviourally stablevariable.Thus in the adjusted H
approach the partialderivative of m with respect to r is effectively capturing the effect of
changes in the excess reserveson the money multiplier

However, to calculate the total effect on m of the expected change in each of the ratios c,r
,t, we need to estimate the partial effect on m of each of them and adding
up.Differentiating m = m (c ,t ,r ) totally and taking discrete approximations, we get

(iv) change m = del mchange c + del mchange t +del mchange r + E

del c del t del r

With E representing the residual consequent to taking discrete approximations.The 3

terms on the right hand side represent the partial contribution to the change in m of the
change in each of the ratios c ,t ,r.The sum of these terms constitute the explained portion
of changes in m. that is del m , del m , del m are got from equations (i), (ii) and (iii).and

del c del t del r

change in c,change in r ,change in t are either observed or predicted. This implies that all
the terms on the right hand side of equation (iv)can be estimated

The relative contribution of each of the ratios to the changes in m can be found by
dividing both sides of equation (i v) by change in m to yield

1 = del m.change in c +.del m.change in t +delm.change in r + E

del c change in m del t change in m del r change in m change in m

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We can calculate both the average as well as the marginal

multipliers for India for both the narrow as well as broad Money by taking the following
ratios----- M1/H, M3/H and----- change in M1 and M3/changes in H.

1The average broad money multiplier during the 1990s wasplaced at 3.37 compared with
the average narrow money multiplier of the order of 1.15 during the same period.The
corresponding incremental money multipliers (i.e change in money stock divided by
change in reserve money) were placed on an average basis at 5.42 and 1.55 for broad
money and narrow money respectively.The multipliers .m1 and m3 increased during the
1990s vis a vis 1980s because of reduction in cash reserve requirement that is r r.The
average money multiplier was fairly stable in absolute terms with a coefficient of
variation of 4.7% for m1 and 10.0% for m3during the 1990s-but volatile in incremental
terms 72.9 % for m1 and 81.7% for m3..Despite this short run volatility of incremental
multiplier,it is stable in the long run implying a long run stable relationship existing
between H and M3 with elasticity close to 1.

3.2Currency / Demand Deposits ratio

Of the three proximate determinants of the money multiplier,the ratio C/DD occupies a pivotal
position.Seen as a perpetrator of business cycles by some economists,or as a proxy for the
degree of financial development by others,in the money multiplier theory,it plays an important
role by determining along with the T/DD and R/D ratio, the magnitude of the money multiplier

The C/DD ratio conveys the choice of the public between the two componentsof narrow money
which has important consequences for the money supply analysis.For the higher the C/DD ratio,
the greater the leakage of High Powered money,and therefore the smaller is the secondary
expansion of Money Supply.Both C/DD and T/DD thus constituteleakages from the money
supply process.It is crucial for this purpose to identify its determinants and analyse their impact
on the ratio,and further on the multiplier.

To look at the behavior of the C/DD ratio over the period 1950-51 to 2003 -2004 we observe,.

.It was 2.34 in 1950-51 to 1.53 in 1970-71 ,1.49 in 1980-81 to 1.37 in 2003-2004.In terms of its
profile therefore it has been decreasing overtime despite the fact that both currency and demand
deposits have increased in nominal terms in proportion to the increase in income .The implication
of the faster growth of demand deposits is clear,and we can try to identify the factors or
determinants whose effect is reflected in this behavior in terms of income elasticities,the relative
costs ,and the structural factors.

.The ratio c = Cd/DDdis a ratio variable of two level demand functions that is, Cd and DDd since
these are components of the aggregate demand for Narrow Money M1,they are affected by the
same set of variables that affect the demand for money.These could be divided into the Scale
Variable( Income ) ,the Opportunity cost variable (rate of Interest) ,Structural Variables( Spread
of Banking Facilities, Black Money)

Scale Variable :Income

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The growth of income in a growing economy is associated with

a variety of institutional changes,primary amongst which is
monetization.Monetization is associated with a variety of changes like spread of banking facilities
into unbanked areas,migration from rural to urban areas,changingsectoral composition of the
economy,growth in literacy,better transportation and communication network,commercial and
industrial development.Income acts as a proxy for most of these developments.However since
both the demand for currency as well as the demand for demand deposits tend to increase with
increases in income,a declining C/DD ratio indicates that the income elasticity of currency
demand is less than that of demand deposits.That is ,with increases in income and monetization,a
larger number of agricultural and retail transactions would be settled through the medium of
currency rather than barter.However income increases are associated with the spread of banking
facilities and an increased supply of demand deposits leading to a faster growth of these deposits
relative to currency.

Opportunity Cost Variable :The Rate of Interest

The interest rates on alternative competing assets to currency and demand deposits are the
opportunity costs that affect the choice between these assets and currency and demand
deposits.These short term assets which compete in thepublics portfolio choice are close
substitutes for currency and demand deposits .Hence rate of interest on12 month fixed
depositswithscheduled commercial banks would be relevanthere.Another factor could be the fees
on deposits per cheque or ATM withdrawl which affectsthe choice of C/DD ratio as it is the cost
of holding money in the form of deposits.

Structural Variables

The spread of banking facilities amongst the population is likely to affect the C/DD ratio as it
would enable the public to move out of currency into DD deposits and hence could be the cause
of a decline in the C/DD ratio.Another factor which could affect this ratio is Black Money
Holdings .In a period of high taxation,people have an incentive to evade taxes and hold them as
currency

3.2 Time Deposit/ Demand Deposit Ratio

Apart from the C/DD ratio the T/DD ratio is also affected by the decisions of the
public.The impact of this ratio is different on the narrow and broad Money multiplier..A
rise in the T/DD ratio would lower the value of the narrow money multiplier and raise
that of the broad Money multiplier

The T/DD ratio has increased steadily over the years from 0.53 in 1950-51 to 1.27 in
1970-71 to 3.63 and further to 6.23in the periods 1980-81 and 2003-04.This reflects the
rapid expansion of the banking system and the asset preferences of the public. .It has
been observed that the growth in time deposits is more,relative to that of demand
deposits and there is ashift in the preference not for illiquidity,butfor higher returns
longer maturity period deposits.Growing competition from non bank financial institutions
and the inflationary pressures have led to a fall in their real rate of return,yet the
distribution of the deposit increase is in favour of Time Deposits.We can now look at the
key determinants or explanatory Variables responsible for the observed behavior of the
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ratio.The choice of the public between these two

categories of deposits is governed largely by considerations of Liquidity,Profitability( in
terms of higher interest income earned) and individual time preference in portfolio
management.

Scale Variable:Income

Looking at real income as a scale variable,it has been observed that the income elasticity
of demand for demand deposits is lower,vis a vis demand for time deposits.Time
Deposits are a form of savings and not a medium of exchange,therefore as the level of
savings increase with a rise in income, people hold more time deposits.Since Income acts
as a proxy for alarge number of variables associated with growth,like spread of banking
facilities,industrialization,urbanization,education,transportation e.t.c,their impact may
also indirectly influence the asset choices of the public

Opportunity cost variable:Interest rate

The choice of the public in favour of time deposits is bound to be

governed,however,largely by interest rate considerations.This is so,because time deposits
as saving instruments have to compete with other financial assets whose rate of return
and riskiness becomes important and is hence picked up by the rate of the interest.The
interest rates which can be treated as opportunity cost variables are rates of return on post
office saving deposits,rates of return on ordinary and preference shares, rates of return on
private company deposits of various maturities along with the rates of interest on small
saving schemes.The T/DD ratio is a decreasing function of these opportunity cost
variables.

Structural Variables

The spread of banking facilities would have no differential impact on the T/DD ratio as
there would be growth in both demand and time deposits.Similarly increase in Tax rates
would lead to holdings of black money whichare mostly held as cash,but may even be
held in the form of fixed deposits in different banks under the account of different
family members to escape detection.

3.3 Reserve Ratio

The reserve ratio of commercial banks is the one factor in the expression for the money multiplier
which is not directly affected by the behavioural choices of the public.It is an important decision
banks make in determining their portfolio composition in an effort to strike a balance between the
considerations of liquidity profitability and safety.The basic choice is between cash and non cash
assets or earning assets.The portfolio composition is affected by legal restrictions,as well as by
institutional changes.Forexample,nationalization,amalgamation and liquidation of weak
banks,strengthening of paid up capital requirements of banks,depositinsurance,supervision and
inspection of banks by the RBI improvetheir internal health and strength while the
continuousavailability of funds in the call money market and the presence of RBI as a lender of

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last resort improve the stability of monetary system and lessen

the need of banks to keep cash reserves.In the short run
however,the banks demand for cash reserves may reflect changes in interest rates and the demand
for bank loans

The R/D ratio is composed of two ratios the RR/D ratio and the ER/D ratio.The RR/D is due to
the imposition of the statutory cash reserve requirement imposed by the monetary authorities on
the banks to be kept as a proportion of their demand and timeliabilities as balanceswith the
RBI.In India ,this ratio had increased to the highest of 15% by 1990 and was ,according to the
recommendations made by the Narasimham Committee Report,reduced gradually over a period to
5%

The residual reserves or excess reserve ratio ER/D are held either as cash in hand or as balances
with the RBI.It is these reserves which the banks as a whole use to meet their currency drains i.e
(net withdrawl of currency by their depositors) as well as clearing drains i.e (net loss of cash due
to cross clearing of cheques amongst banks.These drains on the reserves of the banks arise if
there is a big enough shift in the asset preferences of thepublic from bank deposits to currencyor
due to drains of cash from one bankto other banks withinthe system.Temporary accommodation
may be provided,though at a cost in the form of RBIrefinancing.or through borrowing in the inter
bank call money market.The excess reserve ratio in India have been steadily decreasing over
time.From 2.9% in 1960 ,it fell to 2-1% in 1975 and just 1.1% in 1986.This was due to the
growth of the call money marketwhich encouraged the banks to lend in and borrow from the call
money market and hold less excess reserves.Similarly better utilization of RBI refinance facilities
have necessitated a lower holding of excess reserves by banks

To discuss the ultimate determinants of this ratio we look at the scale,interest and structural
variables

Scale Variable:Total Deposits

The scale variable which affects the reserve ratio in the case of banks would be its net demand
and time liabilities.which can be represented by the banks Demand and Time Deposits.Since the
reserve ratio is a proportion of these deposits,an increase in these deposits would have a positive
impact on the reserve ratio

Opportunity Cost Variable : Interest Rates

These represent the cost of holding cash by the banks.Since the banks could have made loans and
advances,the interest on these is one such opportunity cost.Similarly the marginal cost of
borrowed funds by the banks can be the Bank Rate which the banks have to pay to the RBI or the
Call Money Rate which is the cost of borrowing from or lending in the Call Money Market

Structural Variable

Institutional improvements in the Banking system reduce the liquidity requirements of banks and
strengthen the banking system through weeding out of weak units.Deposit insurance and
Nationalisation have increased the faith in the banking system.An enlarged interbank call money
market and easier access to the RBI for loans also obviates the need to keep ER by banks..

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4. MONEY SUPPLY RESPONSE

The money stock is negatively related to the currency deposit ratio because a rise in C/DD ratio
brings about a shift from deposits to currency and since deposits undergo multiple expansion
while currency does not,the net result is contraction of the money multiplier and of the Money
stock.

Initially reserve ratio on time deposits were lower than those for demand deposits.Then,an
increase in TD/DD ratio raised the availability of free reserves and the consequent enlargement
of the volume of multiple depositexpansion leads to monetary expansion.In the case of narrow
money multiplier,an increase.in TD/DD ratio leads to monetary contraction when TD/DD ratio
rises,the amount of bank reserves required to support time deposits increases,i.e smaller reserves
are available to support demand deposits.This implies that the narrow money multiplier
falls,leading to narrow money contraction.However,there will be an increase in the broad money
supply due to increase in the Time deposits and increase in the broad money multiplier.

Enhancement of the reserve ratio or a rise in banks’holding of excess reserves leaves less reserves
free to support bank deposits,thereby leading to monetary contraction both in narrow as well as
broad money.

5 Summary

· Identified the proximate determinants of the narrow and broad money multipliers
as c ,t ,r
· The effect of changes in c , t, r on the money multipliers
· The time profile of the average and marginal multipliers showing long run
stability.
· The ultimate determinants of the proximate determinants in terms of the
scale,interest,and structural factors
· The ultimate determinants of the C/DD ratio are Income,rate of interest on 1 year
fixed deposits,spread of banking facilities,Increased tax rates leading to holdings
of black money in the form of currency holding.
· The ultimate determinants of the T/DD ratio are Income,rate of interest on post
office deposits,rates of return on ordinary and preference shares and company
deposits of various maturities along with the rate of interest on small saving
schemes.
· The ultimate determinants of the reserve ratio R/D are Total Liabilities/Total
Deposits of Banks, the rate of interest earned on loans ,the Bank rate,Call Money
rate and various measures to strengthen the banking system like Deposit
Insurance,Nationalisation of Banks, enlargement of the Call Money market.
· A rise in the C/DD ratio leads to a fall in the narrow and broad money multipliers
and hence a fall in the narrow and broad money supply because less reserves are
available for secondary deposit creation with increased holdings of Currency.
· A rise in the T/DD ratio leads to a fall in the narrow money multiplier but a rise in
the broad money multiplier and a corresponding Decrease and Increase in the
Narrow and Broad Money supply respectively.
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