UNIT 4

MONEY SUPPLY
INTRODUCTION: Money significantly affects the level and nature of economic
activities. It affects the operative forces of the economy through its effects on the
level of aggregate expenditure and the consequent effect on the general price
level If the supply of money exceeds the demand, it increases the rate of
expenditures and brings about a rise in the price level and vice versa.A necessary
condition for equilibrium of the rate of expenditures, therefore is that the supply of
money should be equal to the demand for money.
THE SUPPLY OF MONEY : Money is defined as anything which is used as a
general medium of payment and which is denominated in terms of the monetary
unit of account.One of the most important properties of money is liquidity ie the
ability to be converted into spendable form easily without any loss to the holder.
Money is thus spendable, marketable and easily transferable. The term supply of
money refers to the stock of money held by the public in spendable form in a
country. The term public refers to all categories of holders of money except
 central government or treasury ,central bank and the commercial banks.Public will
include individuals, business firms, industrial undertakings, state and local
government bodies.
Money supply with the public or the privately held money supply comprises private
holdings of currency and demand deposits held by the public in banks
M = C + DD. Currency is issued by the central bank and the central government in
the form of currency notes and coins.Demand deposits are created by commercial
banks against a primary deposit.There are several problems associated with the
measurement of money supply. If we add up total currency and demand deposits
there is likely to be double counting because the primary deposits arise mainly
from a deposit of cash .Therefore we exclude cash reserves held by banks.Inter-
bank deposits and currency and deposits of central bank and central government
held as reserves are also excluded.
Conceptual Issues Determining Money Supply
There are two broad approaches adopted by monetary economists in providing a
workable definition of money supply.The traditional approach seeks to
characterise money as the medium of payment,something which essentially
facilitates transactions between people.This approach considers money supply as
the amount held by the public in spendable form only ie M = C + DD.The other
approach considers money to be one among several assets .This emphasises the
role of money as the temporary abode of purchasing power .This involves
emphasis on near money assets as alternative sources of liquidity.
For analytical and practical purposes money must be statistically measurable. This
is because any change in the money supply affects the functioning of the
economic system
Ordinary Money and High Powered Money
To study the theory of money supply, money is sometimes distinguished as a)ordinary money M and
b) high powered money H. M is the sum of currency with the public ie M = C + DD . H is money
produced by the central bank and the Government and held by the public and banks. It is the sum
of i) currency held by the public and ii) cash reserves of banks.It is also known as reserve money.
The distinction between M and H is of crucial importance for the theory of money supply Banks are
creators of bank deposits which are considered to be money at par with currency. In order to create
these demand deposits, banks have to maintain reserves which are a part of H, produced by the
monetary authority and not by the commercial banks themselves Currency is common to both M
and H. The only difference between the two is that whereas demand deposits are a component of
M,reserves are a component of H
In a fractional reserve system , demand deposits are a certain multiple of reserves, which are a
component of H, it imparts
to H the power of serving as the base for the multiple credit creation by the commercial
banks. For this reason H is called as base money and the H theory of money supply as
the money multiplier theory of money supply.The ratio of M to H is the money multiplier
ratio
The RBI calls H reserve money (RM). It is the sum of i) currency with the public ii) other
deposits with RBI and iii) Bankers deposits with RBI. Since H is money produced by the
monetary authority/government and held by the public and the banks it is the same thing
as the monetary liabilities of the RBI.The sources of changes in the Reserve Money are
1) RBI’s claims on a) government b) Scheduled commercial banks c) state Co-
operative Banks and d) financial institutions like NABARD, IDBI and others
2) Net Foreign Exchange Assets of the RBI
3) Government’s Currency Liabilities to the Public
4) Net Non Monetary Liabilities of the RBI
The amount of reserve money can be estimated by deducting the non- monetary
liabilities from the monetary liabilities
Thus Ordinary Money M = C + D ( currency held by public plus demand deposits
H = C + R ( currency held by public plus cash reserves of
the banks). These reserves are further divided into required reserves (RR) and
excess reserves (ER). Thus H = C + RR +ER.
Banks demand for reserves depends upon the volume of their deposits . The
demand for deposits is affected largely by the same factors that affect the demand
for currency such as the level of income and the rate of interest among other
things.Therefore the demand for currency and demand deposits will be highly
correlated . The demand for H can thus be expressed as a function of D and two
ratios namely the currency to deposit ratio ( C/D = Cr and the reserve to deposit
ratio ( R/D = RRr + ERr)
The relationship between M and H can be expressed as a ratio between the two
The equation shows that money supply M is determined by four factors namely H,
Cr,RRr and ERr. A Increase in H leads to an increase in money supply and vice
versa.If on the other hand Cr. RRr and ERr increase then there will be a decrease in
the money supply. Thus money supply varies directly with H and inversely with
Cr,RRr and Err.This gives the value of what is known as the money multiplier m ie
m = 1 + Cr / Cr + RRr + ERr . Thus M = m.H
Determinants of Money Supply - The total quantity of money supply in the form
currency and demand deposits is determined by the following factors
1. One of the most important factors influencing the money supply in an economy
is the size of the monetary base . The monetary base is made up of and varies
with the monetary gold stock, money issued by the central bank and the amount
of central bank credit outstanding.The importance of the different components
depends upon the type of monetary system eg in gold standard gold stock was
very important
2. Another factor affecting the money supply is the community’s choice as to the relative amounts of
cash and demand deposits that it wishes to hold.Factors like charges on deposits, interest rates on
alternate assets will influence the ratio of currency to deposits
3. Ratio between bank reserves and deposits. The higher the ratio of reserves to deposits the
smaller will be the amount of demand deposits created. Need to distinguish between required
reserves and excess reserves.The amount of excess reserves held by commercial banks will be
influenced by the market rate of interest on loanable funds, cost of borrowing and their expectations
wrt withdrawal of cash by the customers
4. The demand for bank credit.Depends on the level of economic activity and the marginal efficiency
of capital.it also depends upon objective factors like banking facilities,service charges, general
acceptability of cheques, development of banking habits etc
6. The credit control policy of the central bank
7. Interest rate -higer the interest rate offered on alternative assets, lesser will be the number of bank
deposits and hence lesser multiple credit creation and hence money supply
8. Confidence in the banking system ; During periods of prosperity confidence is high so c and r
ratios will tend to fall leading to an increase in the money supply
9. Size of the money multiplier - larger the size of the multiplier greater will be the
money supply. The value of the multiplier depends on the currency to deposit ratio
and the reserve to deposit ratio. A reduction in currency to deposit ratio and a
reduction in reserve to deposit ratio will lead to an increase in the money supply in
the economy and vice versa.
10. Income Levels -Higher the income levels greater will be the amount of demand
deposits and hence larger will be the money supply in an economy.
Illegal activities-As most of these activities are carried out using currency they do
not enter into the banking system as deposits and hence money supply will be
less.