Supply of

Money
 How the Money Supply Is
Determined

• An economy’s money supply is controlled by its central bank.

• The central bank:
• Directly regulates the amount of currency in existence
• Indirectly controls the amount of chequing deposits issued by private
banks
 Money Supply

M=C+D

C = Currency: coins & bills (13.5%)

D = Demand Deposits: checking

account deposits (86.5%)
 Concepts of Money
• Globally there are two measures of money:
• Narrow money
• Currency with the public and demand deposits with the banks
• Broad Money
• Narrow money plus time deposits with banks
The Working Group on Money Supply 1998 headed by Dr. Y.V. Reddy
recommended compilation of four monetary aggregates, i.e.,
M0(monetary base), M1 (narrow money), M2 and M3 (broad money).
 Monetary Base (M0)

It consist of
• Currency in Circulation
• Bankers' Deposits with the RBI
• 'Other' Deposits with the RBI
 Narrow Money M1
It consist of
• Currency with the Public
• Current Deposits with the Banking System
• Demand Liabilities Portion of Savings Deposits with the
Banking System
• 'Other' Deposits with the RBI
 M2
• Currency with the Public
• Current Deposits with the Banking System
• Savings Deposits with the Banking System
• Certificates of Deposit issued by Banks
• Term Deposits of residents with a contractual maturity up
to and including one year with the Banking System
• 'Other’ Deposits with the RBI
 B R O A D M O N E Y (M3)

• M2
• Term Deposits of residents with a contractual maturity
of over one year with the Banking System
• Call/Term borrowings from 'Non-depository‘
Financial Corporations by the Banking System
 Money Supply Function

M=C+D
H=C+R

where M = money supply

C = currency with public
D = bank deposits
H = high powered money
R = bank reserves
• High powered money, is also known as reserve money, government money and
monetary base (it has the capacity to create more money and it represents the
liabilities of the government
 A few preliminaries
• Reserves (R ): the portion of deposits that banks
have not lent.

• To a bank, liabilities include deposits,

assets include reserves and outstanding loans

• 100-percent-reserve banking: a system in which

banks hold all deposits as reserves.

• Fractional-reserve banking:
a system in which banks hold a fraction of their
deposits as reserves.
Money creation in the banking system

A fractional reserve banking system

creates money,
but it doesn’t create wealth:
bank loans give borrowers
some new money
and an equal amount of new debt.
 Money Multiplier
Money multiplier is the process through
which banks create more money through its
excess reserves, thereby expanding money
supply.

In other words, its process of creating

more money by banks from reserve
money.
 Money Multiplier

In order to derive a money Multiplier we have to

divide the total money supply with Reserve Money
M/B= C+D/C+R
Divide both the top and the bottom with D
M/B=C/D+1/C/D+R/D
of which
C/D-Currency deposit Ratio -cr
R/D is Reserve-Deposit Ratio- rr
Replace them appropriately and Bring B to right
side
 Money Multiplier
Then,
M=(cr+1/cr+rr ) *B

This equation shows how the money

supply depends on the three exogenous
variable
We can also see that the money supply is
proportional to the monetary base. i.e.,
M= m*B
 Money Multiplier Example
Suppose that the monetary base B is $800
billion,
the reserve–deposit ratio rr is 0.1, and the
currency–deposit ratio cr is 0.8.

1. What is the Value of money multiplier is?

2. What is the Money Supply
 Money Multiplier Example

1 Ans. Money multiplier is m=0.8+1/0.8+0.1 = 2.0

2. The money supply is M = 2.0 × $800 billion =

$1,600 billion
Money Supply (Broad Money), Reserve
Money (H) and Money Multiplier in India
The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand

• Equilibrium in the Money Market

• The condition for equilibrium in the money market is:
Ms = Md
• The money market equilibrium condition can be
expressed in terms of aggregate real money demand as:
Ms/P = L(R,Y)
 Change in Money Supply
• The money supply is proportional to the monetary
base. So, an increase in H increases M m-fold.

• The lower the reserve-deposit ratio, the more loans

banks make and the higher is the money multiplier

• The lower the currency deposit ratio, the fewer rupees

of the monetary base the public holds as currency and
the lower is the money multiplier
 Review: Money Demand

• The amount of money demanded for transaction

and speculative purposes depends: personal income
and interest rate

• At any level of personal income, quantity

demanded of money is a negative function of
interest rate; (M/P)d = L(i, Y)
The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand
Figure : Determination of the Equilibrium Interest
Interest
Rate
rate, R
Real money supply

2
R2

1 Aggregate real
R1 money demand,
3 L(R,Y)
R3

Q2 MS ( = Q 1 ) Q3 Real money
P holdings
 The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand

• Interest Rates and the Money Supply

• An increase (fall) in the money supply lowers (raises) the
interest rate, given the price level and output.
• The effect of increasing the money supply at a given price
level is illustrated in the next Figure
The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand
Figure : Effect of an Increase in the Money Supply on the
Interest Rate
Interest
rate, R
Real money
supply Real money
supply increase

1
R1

R2 2

L(R,Y1)

M1 M2 Real money
P P holdings
The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand

• Output and the Interest Rate

• An increase (fall) in real output raises (lowers) the
interest rate, given the price level and the money
supply.
• Next Figure shows the effect on the interest rate of a
rise in the level of output, given the money supply and
the price level.
The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand
Figure: Effect on the Interest Rate of a Rise in
Interest Real Income
rate, R
Real money supply

Increase in
real income

2
R2
1 1'
R1 L(R,Y2)
L(R,Y1)

MS ( = Q 1 ) Q2 Real money
P holdings