MONEY SUPPLY (FOR B.COM 3rd Year, B.Sc/B.A 1st year)

Money supply

Definition of money: Money is defined as the stock of assets that can be readily used to make transactions. In other words, money is simply the total stock of currency in the hands of the public of any economy.

Functions of money:

1.       Medium of exchange: Money is used to buy goods and services (G&S) that individuals want. It can therefore, be used as a medium of all kinds of transactions in the economy. In any economy, the ease with which money can e converted to purchase other things is known as liquidity of money.

2.       Store of Value: money is also used to transfer purchasing power from present generation to the future or from present period to the future. Although, such store of value as a function of money is not perfect due to the possibility of inflation, which reduces purchasing power of money overtime. Yet, individuals can trade money by saving it now and spending it in the future.

3.       Unit of Accounts: In the credit market, all the lending and borrowing is recorded in terms of money. Also in any market in the economy, money is quoted as the price for the commodity or service and hence it acts as a yard- stick with which all, the economic transactions are measured.

Types of money

Money that has no intrinsic value of its own but is established as money by the governments’ order or decree is known as fiat money.

On the other hand, when some commodity is utilized as money because of its intrinsic value, then it is called commodity money. The most widespread example of commodity money is gold coins, where gold as a currency is used as money and those economies using such gold coins are said to be on gold standard.

Measures of economy

Mₒ - it comprises the total currency in the hands of the public in any economy. It is also known as the “Base Money.”

M₁ - it comprises currency in the hands of public, i.e., Mₒ, as well as demand deposits, travellers’ cheque and other chequeable deposits.

M₂ - it includes M₁ + Saving Deposits + Small time deposits + Money market mutual fund balances

M₃ - M₂ + long-term deposits + euro dollars + institutions – money market mutual funds only.

Central Bank

ASSETS	LIABILITIES
1.       Government borrowings (Domestic Credit/DC)	1.    Currency (C)
2.       Commercial bank borrowings (Discount Window Operation/DW)	2.    Reserves (R/SLR)
3.       OMOs (Government Bonds/B)
4.       Foreign Exchange Reserves (F)

Assets – Side explanation:

1.       The RBI (Central Bank) advances credit to the government as the financier of the government. In case of deficit financing, the additional government expenditure is financed by borrowing from the Central Bank.

2.       The Central Bank also provides credit to the commercial banks through the discount window mechanism when the commercial banks have shortage of funds.

3.       The Central Bank also controls the Capital market of the economy and it is the absorber of government bonds. When the Central Bank on behalf of the government operates through open market purchase of government bonds, the stock of government bonds with the Central bank goes up, this adds to the Asset value of the Central Bank.

4.       The Central Bank is also the custodian of foreign exchange reserves in the open economy. It is found that if the domestic currency appreciates then there is a fall in the foreign exchange value while if the domestic currency depreciates there is an increase in the foreign exchange reserve value.

Liabilities – Side explanation

1.       Currency – the Central Bank of any economy has the monopoly right over the issue of currency, which is then circulated among the citizens.

2.       Reserves – the Central Bank also keeps reserves in the form of Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR), which belongs to the Commercial Bank for emergency requirement in order to solve (mitigate) the problem of bank-run.

Now, the total value of assets and liabilities of the Central Bank comprises the base money or outside money or simply High Powered Money. Therefore, the high-powered money comprises the monetary base of the economy.

Therefore, from Assets side,

DC + DW + B + F = H (high powered money)  → Supply Side Equation

                                               

Similarly, from liability side,

C + R = H  →  Demand Side Equation

                                          

Commercial Bank

ASSETS	LIABILITIES
Loan (L)	Deposits (D)
Reserves (R)

Derivation of Money Multiplier

1.       Currency- Deposit Ratio- it is defined as the ratio of the amount of currency held as liquid cash in the hands of public to the amount of deposits that is saved in the banks. It is normally denoted by:-

                               β = C÷D

2.       Required Reserve Ratio, Excess Reserve Ratio and reserve Ratio- the reserve ratio gives the fraction of the deposits with the commercial banks that are withheld by them as reserves. It is normally denoted by:-

                               α = R÷D

Since R is a fraction of D for a proper banking system, hence α<1.

The total reserve of any commercial bank comprises of required reserves and excess reserves. The required reserve ratio (RRR) denotes the amount of deposits that has to be kept by the commercial bank as compulsory reserves with the Central bank. This reserve is pre-determined by the Central bank and imposed on all the Commercial Banks as a constant. However, such excess reserves are not compulsorily imposed by the Central Bank and hence its magnitude depends on the policies of individual commercial banks themselves.

Therefore, the fraction of the deposit with the commercial banks that are kept, as excess reserves are known as Excess Reserve Ratio (ERR).

                                      α      =   R÷D    =  (RR+ER)÷D

                                                               =          RR÷D    +      ER÷D

                                                               =           RRR      +       ERR

                                                               =               α₁       +         α₂ ;  where

_α1 =  RRR     (constant)

α_{2 =}   ERR   (variable)

RR – Required Reserve

ER – Excess Reserve

The ER of any commercial bank depends on market interest rate (r), discount window rate of the central bank (r_d) and future uncertainties (σ). Normally, as the ‘r’ goes up the commercial banks want to give out more loans in order to earn more profit and hold less excess reserve. 

Thus, Excess Reserve is inversely related to ‘r’, implying, ERR ∝ 1/r. Similarly, if the central bank charges a high interest rate to the commercial bank as the lender of the last resort, then commercial banks would not opt for the loan from the central bank in lieu to repay a higher amount as debt afterwards, hence they would keep more excess reserve so that they stay safe from such situation. Therefore, the higher is the r_d, the more the commercial banks keep money as excess reserves. This means that Excess Reserve is directly related to ‘r_d’, implying, ERR ∝ r_d.

In addition, w.r.t market uncertainties, we notice that the more are the market uncertainties, the riskier it will be for commercial banks to give out loans and therefore, it holds more ER. Hence, ER is directly related to market uncertainty. Thus, ERR ∝ σ.

Hence, overall, α₂= f(r, r_d, σ).

From the liability side, if you recall,

                         H= C+ R        →        (1)

The money supply in the economy is given by:-

                         M= C + D      →        (2)

      (2) ÷ (1), gives us,

   =>   M÷H = (C+D) / (C+R)

Let us divide R.H.S by D,

   =>  M/H   =   ( C/D + D/D ) /  ( C/D + R/D )  

                              

   =>  M/H   =   ( β + 1 ) /  ( β + RR/D + ER/D ) 

   Now, cross multiplying H, and putting the notations, we get, 

  M = H [ (β + 1) / (β + α₁ + α₂) ]   →  (3)

Now let, m =  (β + 1) / (β + α₁ + α₂)   →     money multiplier

=>  M = mH     →     money multiplier equation

Again, We know, α<1 

=> α + β  < 1 + β 

=> 1 < (1 + β) / (α + β)

=> 1 <  m

Where, α = α₁ + α₂

 ஃ  m>1

Thus, the above result implies that if ‘H’ increases by 1 unit, then the Money supply (M) increases by more than 1 unit, why? Because the money multiplier is greater than 1, so the effect will be greater.

PROBLEM SUM (EXAMPLE):

Given:

(i)  α1 (bar)= RR/D = 0.12, α2 = ER/D = 0, β = C/D = 0.3 , find the money multiplier and money supply amount, if High-powered money (H) is 40 billion.
(ii)  If α1(bar) = 0.2 , then what is the money multiplier value, and what is the change in money supply.

Ans.) (i)  α = α1 (bar) + α2 = 0.12 + 0 = 0.12

 ஃ  m ( money multiplier ) =  (1 + β) / (α + β)  =  (1 + 0.3)/ (0.12 + 0.3) = 1.3/0.42 = 3.095

ஃ  Money Supply = m H = 3.095 x 40 = Rs. 123.8 billion.

         (ii)  Now, if the value of α1 (bar) becomes 0.2, then α = 0.2 + 0 = 0.2

ஃ  m =  (1 + β) / (α + β)  =  (1 + 0.3)/ (0.2 + 0.3) = 1.3/0.5 = 2.6

ஃ  Money Supply = m H = 2.6 x 40 = Rs. 104 billion.

ஃ  The change of Money Supply = 123.8 - 104 = Rs. 19.8 billion.

Thus, the money supply in the economy goes down by 19.8 billion rupees.