macro unit 3

8/7/2019 Macro Unit 3

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SUPPLY OF MONEY The supply of money is a stock at a

particular point of time, though itconveys the idea of a flow over time.

The supply of money at any momentis the total amount of money in theeconomy.

There are three alternative viewsregarding the definition or measuresof money supply.


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Traditional or Keynesian ViewMoney supply is defined as currency withpublic and demand deposits withcommercial banks.

Demand deposits are savings and currentaccounts of depositors in commercialbanks.They are the liquid form of money becausedepositors can draw cheques for any

amount lying in their accounts and thebank has to make immediate payment ondemand.This is denoted as M1.


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Modern Quantity Theory of Money

by Milton Friedman.Money supply at any moment of time asliterally the number of dollars people arecarrying around in their pockets, the

number of dollars they have to their creditat banks or dollars they have to their creditat banks in the form of demand deposits,and also commercial bank time deposits.

Time deposits are fixed deposits ofcustomers in a commercial bank.

This is denoted by M2


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Gurley and Shaw definition

They include in the supply of money, M2plus deposits of savings banks, buildingsocieties, loan associations, and deposits ofother credit and financial institutions.

The first definition may be analyticallybetter because M1 is a sure medium ofexchange. But M1 is an inferior store ofvalue because it earns no rate of interest,as earned by time deposits. Further, thecentral bank can have control over anarrower area if only demand deposits areincluded in the money supply.


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DETERMINANTS OF MONEY SUPPLY Money supply is determined

exogenously by the central bank.

Money supply is determinedendogenously by the changes ineconomic activity which affectpeoples desire to hold currency

relative to deposits, the rate ofinterest etc.


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1. The Required Reserve Ratio The required reserve ratio or minimum cash reserve

ratio is an important determinant of money supply.

An increase in the RR reduces the supply of moneywith commercial and a decrease in RR increases the

money supply. The RR is the ratio of cash to current and time deposit

liabilities which is determined by law.

Every commercial bank is required to keep a certainpercentage of these liabilities in the form of deposits

with the central bank of the country. But notes or cash or cash held by commercial banks

are not included in the minimum required reserveratio.


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The shot term assets along with the cash areregarded as the liquid assets of a commercial bank.

In India statutory liquidity ratio (SLR) has been fixedby law as an additional measure to determine the

money supply. The SLR is called secondary reserve ratio in other

countries while the required reserve ratio is referredto as the primary ratio.

The raising of the SLR has the effect of reducing the

money supply with commercial banks for lendingpurposes, and the lowering of the SLR tends toincrease the money supply with banks for advances.


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2. The Level of Bank Reserves Commercial bank reserves consist of

reserves on deposit with the central bankand currency in their tills or vaults.

It is the central bank of the country thatinfluences the reserves of commercialbanks in order to determine the supply ofmoney.

The central bank requires all commercial

banks to hold reserves equal to a fixedpercentage of both time and demanddeposits. These are legal minimum orrequired ratio.


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Required Reserves are determined by therequired reserve ratio and the level ofdeposits of a commercial bank. RR=RRR x

D It is the excess reserves of a commercial

bank which influence the size of itsliabilities. ER=TR-RR

To determine the supply of money with acommercial bank, the central bankinfluences its reserve by adopting openmarket operations and discount rate policy.


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Open market operations refer to the purchase andsale of government securities and other types ofassets like bills, securities, bonds, etc., bothgovernment and private in the open market.

When the central bank buys or sells securities in theopen market, the level of bank reserves expand orcontracts.

The purchase of securities by the central bank is paidwith for with cheques to the holders of securities who,in turn deposit them in commercial banks therebyincreasing the level of bank reserves.

The opposite is in the case when central bank sellssecurities to the public and banks who makepayments to the central bank through cash andcheques thereby reducing the level of bank reserves.


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The discount policy affects the money supply byinfluencing the cost and supply of bank credit tocommercial banks.

The discount rate, known as the bank rate in India, is

the interest rate at which commercial banks borrowfrom the central bank.

A high discount rate means that commercial banksget less amount by selling securities to the centralbank. The commercial banks, in turn, raise their

lending rates to the public thereby making advancesdearer for them.


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Thus there will be contraction of credit andthe level of commercial bank reserves.

Opposite is the case when the bank rate is

lowered. It tends to expand credit and theconsequent bank reserves. It should be noted that commercial bank

reserves are affected significantly onlywhen open market operations and the

discount rate policy supplement each other.Otherwise their effectiveness asdeterminants of bank reserves andconsequently the money supply is limited.


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3. Publics desire to hold currency

and deposits Peoples desire to hold currency (or cash)

relative to deposits in commercial banksalso determines the money supply.

If people are in the habit of keeping less incash and more in deposits with thecommercial banks, the money supply willbe large.

This is because banks can create moremoney with larger deposits.


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On the contrary, if people do not have bankinghabits and prefer to keep their money holdingsin cash, credit creation by banks will be less

and the money supply will be at a low level. High-powered money is the sum of commercialbank reserves and currency held by the public.

High-powered money is the base for theexpansion of bank deposits and creation of

money supply. The supply of money varies directly with

changes in the monetary base, and inverselywith currency and reserve ratios.


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4. Other Factors

The money supply is a function not only of the high-powered money determined by the monetaryauthorities, but of interests, income and other factors.

The latter factors change the proportion of money

balances that the public holds as cash. Changes in business activity can change the

behaviour of the banks and the public and thus affectthe money supply.

Hence the money supply is not only an exogenously

controllable item but also an endogenouslydetermined item.


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To sum up: Money supply and bank credit are indirectly

related to each other.

When money supply increases, a part of it

is saved in banks depending upon thedepositors propensity to save.

These savings become deposits ofcommercial banks who, in turn lend after

meeting the statutory reserverequirements.

Thus with every increase in the moneysupply, the bank credit goes up.


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Increased money supply = Increased bank credit.. Butnot always as:

A. The MPS does not remain constant. It varies fromtime to time depending on changes in income levels,

prices, and subjective factors. B. Banks may also create more or less credit due tothe operation of leakages in the credit creationprocess.

C. The velocity of circulation of money also affects themoney supply. If the velocity of money circulation

increases, the bank credit may not fall even after adecrease in the money supply. The central bank haslittle control over the velocity of money which mayadversely affect bank credit.


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Demand for moneyThe demand for money arises from two

important functions of money:

Money acts as medium of exchange. It is a store of value.

Thus individuals and businesses wish to

hold money partly in cash and partlyin the form of assets.


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Two views on changes in demand

for moneya. Scale view: Impact of the income or wealth level

upon the demand for money. The demand for moneyis directly related to the income level. Higher theincome level, the greater will be the demand for

money.b. Substitution view: Relative attractiveness of assets

that can be substituted for money. According to thisview, when alternative assets like bonds becomeunattractive due to fall in interest rates, peopleprefer to keep their assets in cash, and the demandfor money increases, and vice versa.


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The scale and substitution view combinedtogether have been used to explain thenature of the demand for money which hasbeen split into transaction demand, theprecautionary demand, and the speculativedemand.

The three main approaches to the demandfor money:

a. The classical approach.b. The Keynesian approach.c. The post Keynesian approach.

macro unit 3

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