Changes in Money Supply: it’s Meaning and Determinants

Changes in Money Supply: it’s Meaning and Determinants!

What brings changes in money supply? Clearly, money supply will change when magnitude of any of its constituents changes.

Let us for the sake of simplicity use most liquid definition of money, viz., M₁ = C + DD + OD.

Clearly, changes in C (currency held by public), DD (net demand deposits in banks) and net time deposits of banks will cause changes in money stock. In addition, various actions of RBI and commercial banks as well as preferences of public for holding cash balance vis-a-vis deposits in banks affect money supply.

These are summarised in the form of following key ratios:

(i) Currency Deposit Ratio (CDR):

It is the ratio of currency held by public to their holdings of bank deposits.

Symbolically:

Cdr = Currency with public / Bank deposits

For example, if a person gets Rs 1, he will put 1/1 + crd account and keep Rs cdr/ 1 + cdr in cash. (1/ 1+ cdr + cdr/ 1+ cdr = 1 + cdr / 1 + cdr = 1). It shows people’s preference for liquidity (cash) which influences money supply.

(ii) Reserve Deposit Ratio (RDR):

It is the proportion (ratio) of total deposits which commercial banks keep as reserves. Banks hold a part of money from people’s deposits as reserve money and loan out the balance to various Investment projects. The reserve money consists of (a) vault cash in banks and (ii) deposits of commercial banks in RBI.

For convenience sake, suppose a bank has a deposit of Rs100, out of which it keeps Rs 20 as reserve money (vault cash Rs 15 + deposit in RBI Rs 5) and loan out Rs 80 (loan Rs 30 + Investment Rs 50). In this case RDR = 20/100 = 0.2. It may be added that in order to control and regulate money supply, RBI uses various policy instruments such as Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). In addition to these ratios, RBI uses Instrument of Bank Rate to control the value of RDR.

(iii) High Powered Money :

The total liability of the monetary authority of the country, RBI, is called the monetary base or high powered money. It is the money created/produced by RBI/Government of India. It consists of currency (notes and coins in circulation with the public and vault cash of commercial banks) and deposits held by government and commercial banks with RBI.

It is high powered money because these are liability to refund deposits on demand from the deposit holders. Again, if a person presents a currency note to RBI, the latter has to pay him value equal to amount printed on the note. Remember, RBI acquires assets against these liabilities.

In short, RBI regulates money supply by controlling stock of high powered money, bank rate and ratio requirements of commercial banks.

Money creation by RBI:

Suppose RBI wishes to increase money supply. For this it will inject additional ‘high powered money’ in the economy. For instance, assume that RBI purchases gold worth Rs 100 crores. This results in an Increase in currency in circulation. Further, suppose that RBI purchases securities worth Rs 400 crores in the open market.

It will Issue a cheque of Rs 400 crores to the seller of the securities. The seller encashes the cheque at his account in say. State Bank of India which receives this amount .Clearly, currency held by the public goes up. Here, comes the part played by Money Multiplier.

Money Multiplier:

Money multiplier (m) is the ratio of total money supply (M) to stock of High Powered Money (H) in the economy.

Symbolically:

M = M/H

Where m represents money multiplier, M total money supply and H represents stock of High Powered Money. Clearly, value of multiplier m is greater than 1 (m > 1) because increment in M exceeds H initially injected by RBI. Thus, money supply in the economy is determined by the size of multiplier (m) and the amount of high powered money (H). Suppose, value of m =1.5 and that of H = Rs 1,000 crores. Then total money supply (H) will be 1,000 x 1.5 = Rs 1,500 crores. In short, this is the process of money creation.