CH 8(2) Money Supply 🗒️

Measuring Money Supply 🎀Here's a simplified explanation:

Measuring the money supply is important for
two main reasons:

1. Understanding Money Growth: By

analyzing how much money is in circulation,
we can better understand what's driving
changes in the money supply. This helps
economists and policymakers get a clearer
picture of what's happening with the
economy.

2. Managing Monetary Policy: Central banks

use monetary policy to stabilize prices and
promote economic growth. They do this by
controlling the supply of money. By
measuring the money supply, central banks
can see if there's too much or too little money
in the economy compared to what's needed
for stable prices and economic growth. They
can then adjust their policies accordingly to
keep the economy on track.

In simple terms, measuring the money supply

helps economists and policymakers
understand how the economy is doing and
whether it's necessary to make any
adjustments to keep things stable and
growing.

The Sources of Money Supply ☘️First major source of money supply:-

 Sure, let's simplify it:

1. **Factors Affecting Money Supply:**

- Money supply in an economy depends on
two main things:
- Decisions made by the central bank.
- How commercial banks respond to policy
changes initiated by the central bank.

2. **Nature of Money:**
- Money can either have intrinsic value itself
or represent ownership of something
valuable, like commodities or debt
instruments.
- In modern economies, currency is a form
of money issued by the government or central
bank. It's considered legal tender, meaning
it's accepted as payment for goods and
services.
- Paper currency is essentially a type of
debt. It's a liability for the central bank and an
asset for the people who hold it.

3. **Central Bank's Role:**

- Central banks have the authority to issue
currency, making them the primary source of
money in most countries.
- The currency issued by central banks is
called fiat money. It's not backed by a
physical commodity like gold but is
guaranteed by the government.
- Ideally, the currency issued by the central
bank should be backed by assets like gold
and foreign exchange reserves. However,
most countries operate on a minimum
reserve system, where the central bank only
needs to keep a certain minimum amount of
reserves to issue currency.

☘️Second Major source of money supply:-

● The second major source of money
supply is the banking system of the
country.
● Banks create money supply in the
process of borrowing and lending
transactions with the public. Money so
created by the commercial banks is
called 'credit money’
● Advancement in technology has made

Measurements of money supply
M1 = Currency notes and coins with the
people + demand deposits with the
banking system (Current and Saving
deposit accounts) + other
deposits with the RBI.
M2 = M1 + savings deposits with post
office savings banks.
M3 = M1 + time deposits with the banking
system.
M4 = M3 + total deposits with the Post
Office Savings Organization
(excluding National Savings Certificates).
it possible for the development of new
form of money viz. Central Bank
Digital Currencies (CBDCs).
● Reserve Bank broadly defines CBDC
as the legal tender issued by a central
bank in a digital form.
● CBDCs would appear as liability on a
central bank’s balance sheet.
● The Crypto currencies face significant
legislative uncertainties and are not
legally recognized in India as
currency. Hence, these are not
categorized as money.
🧸Sure, here's a simplified mind map:
```
Reserve Bank of India (RBI) Measures of
Money Supply:
|
|-- Monetary Statistics Compilation:
| |
| |-- Since July 1935, RBI compiles and
publishes monetary statistics.
|
|-- Evolution of Money Supply Measures:
| |
| |-- Till 1967-68: Only M1 (Narrow
measure) published - Currency + Demand
Deposits.
| |
| |-- From 1967-68: Introduction of AMR
(Aggregate Monetary Resources) - Broader
measure.
| |
| |-- Since April 1977: Four measures
introduced as per SWG(Second Working
Group Of money supply) recommendations:
| |
| |-- M1: Currency + Demand
Deposits + Other Deposits with RBI.
| |
| |-- M2: M1 + Savings Deposits with
Post Office.
| |
| |-- M3: M1 + Time Deposits with
Banks.
| |
| |-- M4: M3 + Total Deposits with
Post Office Savings Org. (Excluding NSCs).
 |
|-- Definitions of Money Supply Measures:
|
|-- M1: Currency + Demand Deposits +
Other Deposits with RBI.
|
|-- M2: M1 + Savings Deposits with Post
Office.
|
|-- M3: M1 + Time Deposits with Banks.
|
|-- M4: M3 + Total Deposits with Post
Office Savings Org. (Excluding NSCs).
```

This mind map simplifies the evolution and

definitions of the various measures of money
supply prepared and published by the
Reserve Bank of India.

Determinants of Money Supply 🌸Here's a simplified explanation:

Determinants of Money Supply:
1. Exogenous View: Some believe that the
central bank determines the money supply
from outside factors.
2. Endogenous View: Others think that
changes in economic activities, like people's
preference for holding cash versus deposits
and interest rates, determine the money
supply.
3. Current Approach: The current practice
focuses on the "money multiplier approach."
This approach looks at the relationship
between the money stock and the monetary
base, which is the sum of currency in
circulation and bank reserves.
4. Money Multiplier Concept: Before
understanding the determinants of money
supply, it's essential to know about the money
multiplier.

In simple terms, the determinants of money

supply are explained based on how the
central bank, commercial banks, and the
public interact, and how changes in the
economy affect people's behavior regarding
money.

Concept of Money Multiplier 🔖Here's a simplified explanation:

 The Money Multiplier Concept:
- When the Reserve Bank of India creates
money, it's called the monetary base or
high-powered money.
- Banks also create money by giving out
loans. They use their excess reserves to
make these loans and earn interest.
- A one-rupee increase in the monetary base
leads to more than a one-rupee increase in
the money supply. This increase is called the
money multiplier.
- The money supply is the total amount of
money in the economy, including currency
held by the public and bank deposits.
- We can calculate the money supply (M)
using the money multiplier (m) and the
monetary base (MB). The formula is M = m x
MB.
- The money multiplier (m) is a ratio that
shows how changes in the money supply
relate to changes in the monetary base. It's
the ratio of the stock of money to the stock of
high-powered money.
- For example, if the central bank injects
Rs.100 crore into the economy, and it leads to
a Rs.500 crore increase in the final money
supply, the money multiplier is 5. This means
that each unit of the monetary base creates 5
units of money supply.
- The size of the money multiplier depends on
the reserve ratio. The reserve ratio is the
fraction of deposits that banks keep as
reserves. The money multiplier is the
reciprocal of the reserve ratio, which means
it's 1 divided by the reserve ratio (1/R).
- The reserve ratio determines how much
money banks can create from the reserves
they hold. If the reserve ratio is low, banks
can create more money, leading to a higher
money multiplier. If the reserve ratio is high,
the money multiplier is lower.

The Money Multiplier Approach to Supply 1. The behaviour of the Central Bank
of Money

Here's a simplified explanation:

🖤Here's a simplified explanation:
The Central Bank's Role:
The Money Multiplier Approach: - The central bank controls the
- Proposed by Milton Friedman and Anna issuance of currency.
Schwartz in 1963.
- It considers three factors that directly
affect money supply:
(a) High-powered money (H): This is the
money created by the central bank.
(b) Reserve ratio (r): This is the ratio of
reserves that banks keep to the deposits
they hold. It reflects how much banks
keep in reserve compared to how much
they lend out.
(c) Currency-deposit ratio (c): This is the
ratio of currency held by the public to
bank deposits. It shows how much people
prefer to hold in cash versus keeping it in
banks.
These factors represent the behaviors of:
- The central bank (high-powered money).
- Commercial banks (reserve ratio).
- The general public (currency-deposit
ratio).
Now, let's see how each factor affects the
overall money supply in the economy. ➡️
3. The behaviour of the public
🖤 Here's a simplified explanation
incorporating the key points from your notes:
1. **Behavior of the Public:**
- Demand deposits can expand multiple
times, while currency held by the public does
not.
- When deposits are converted into
currency, banks can create less credit money,
reducing the overall level of multiple
expansion and the money multiplier.
- The currency-deposit ratio (c) reflects
people's banking habits and is influenced by
economic activity, financial sophistication, and
access to financial services.
- A smaller currency-deposit ratio leads to a
larger money multiplier because more
high-powered money can be used as
reserves, which then gets transformed into
money.
- The time deposit-demand deposit ratio
affects the money multiplier; an increase
means more free reserves, leading to greater
- It determines the supply of
high-powered money, which is the
basis for the money supply in the
economy.
- The money stock in the economy is
influenced by the money multiplier
and the monetary base (H), which is
controlled by the central bank.
- If the behavior of the public and
commercial banks remains constant,
the total supply of money in the
economy will change in line with the
supply of high-powered money issued
by the central bank.
In simple terms, the central bank
plays a crucial role in controlling the
amount of money in circulation by
regulating the supply of high-powered
money.
2. The behaviour of Commercial Banks
🖤 Here's a simplified explanation
incorporating the key points from your notes:
1. **Commercial Banks' Role in Money
Supply:**
- Commercial banks create money by
issuing loans.
- The behavior of commercial banks affects
the ratio of their cash reserves to deposits,
known as the reserve ratio.
- If the required reserve ratio on demand
deposits increases, banks need more
reserves, leading them to reduce loans,
deposits, and the money supply.
- Conversely, if the required reserve ratio
decreases, banks can expand deposits and
the money supply.
- A smaller reserve ratio leads to a larger
money multiplier, meaning banks can create
more money.
2. **Excess Reserves:**
- Excess reserves are funds that banks
deposit expansion and monetary expansion.
2. **Money Multiplier Determinants:**
- The size of the money multiplier depends
on the required reserve ratio (r), excess
reserve ratio (e), and currency ratio (c).
- Lower ratios result in a larger money
multiplier.
- These variables are known as the
"proximate determinants" of the nominal
money supply.
3. **Money Multiplier Equation:**
- The money multiplier equation includes
the currency-deposit ratio, excess reserves
ratio, and required reserve ratio.
- It's expressed as: m = (1 + c) / (r + e + c)
- The money supply (M) is determined by
the money multiplier (m) and the stock of
high-powered money (H), and varies with
changes in the monetary base, currency ratio,
and reserve ratios.
4. **Example:**
- Imagine a situation where the currency
ratio is low, the excess reserves ratio is
minimal, and the required reserve ratio is low.
In this case, the money multiplier would be
high, leading to a larger money supply.
Monetary Supply and Money Supply
keep beyond the required amount.
- They are crucial in determining the money
supply.
- The excess reserves ratio is negatively
related to the market interest rate.
- If interest rates increase, the opportunity
cost of holding excess reserves rises, leading
banks to decrease excess reserves.
- Conversely, if interest rates decrease, the
opportunity cost of excess reserves
decreases, leading to an increase in excess
reserves.
3. **Impact of Expected Deposit Outflows:**
- If banks anticipate higher deposit outflows,
they increase excess reserves for assurance.
- Conversely, if expected deposit outflows
decrease, banks reduce excess reserves.
4. **Shocks to Money Supply:**
- Commercial banks' behavior can cause
variations in money supply over time.
- During financial crises, banks may be
reluctant to lend, affecting credit availability.
- Rising interest rates on bank credit can
coexist with a central bank's easy monetary
policy, leading to a sharp deceleration in
growth.
🐥Sure, let's break it down:
1. **Stimulating Economic Activity:**
- When a central bank wants to boost
economic activity, it injects liquidity into the
system.
- One way it does this is through open
market operations (OMO), such as buying
government securities.
- This injection of money into the system is
known as high-powered money or the
monetary base.
2. **Effect of Open Market Operations:**
- Assuming banks don't hold excess
reserves and people don't increase currency
holdings, and there's demand for loans, the
banking system creates credit.
- This credit creation process increases the
money supply. The increase in money supply
 (∆Money supply) is calculated as:
∆Money supply = 1 / R × ∆ Reserves
- An open market sale, where the central
bank sells securities, has the opposite effect,
reducing reserves and the money supply.

3. **Possibility of Zero Money Multiplier:**

- The value of the money multiplier could
theoretically be zero.
- This could happen if interest rates are
extremely low, leading banks to prefer holding
the injected reserves as excess reserves
instead of lending.
- Essentially, when banks are reluctant to
lend due to very low interest rates, the money
injected into the system doesn't get multiplied
through the banking system, resulting in a
zero multiplier effect.

Effect of Government Expenditure on

Money Supply
🐣Let's simplify:
1. **Ways and Means Advances (WMA) and
Overdraft (OD) Facility:**
‼️ Credit Multiplier=1/ Required Reserve - When the central and state governments'
Ratio cash balances fall below a certain level, they
can get short-term loans from the Reserve
Bank of India (RBI). This facility is called
Ways and Means Advances (WMA) or
overdraft (OD).

2. **Effect on Excess Reserves:**

- When the RBI lends money to the
governments through WMA or OD, it leads to
excess reserves in the banking system.
- Here's how: When the government spends
money, it transfers funds from its account with
the RBI to the recipient's account at a
commercial bank.
- This transaction increases the commercial
bank's reserves with the RBI, creating excess
reserves.

3. **Impact on Money Supply:**

- Excess reserves created through
government spending can potentially
increase the money supply.
- This happens because excess reserves
can be used by commercial banks to create
more credit and loans, leading to an
expansion of the money supply through the
 money multiplier process.

NUMERICAL ILLUS Pg 8.36