SUPPLY OF MONEY

IMPORTANT OBSERVATIONS:
1. Supply of money is a stock variable
2. Money in hands of public. Public here refers to households, fi rms and institutions. Govt and banking system
are not part of it

MEASURES OF MONEY SUPPLY

 AMR- Aggregate Monetary Resources- M3- emphasises on Store of value function of money

 M1 = C + DD + OD
M2 = M1 + Saving Deposits with Post Offices
M3 = M1 + Net Time Deposits of Banks
M 4 = M3 + Total Deposits with Post Office Savings Organization (excluding NSC)

 3 types of deposits- Demand, time and savings deposits

 New series of Ms by RBI also focuses on cooperative banking sector

 M1- highest liquidity M4- Lowest liquidity

H THEORY OF MONEY SUPPLY:

 Banks follow fractional reserve banking system- keep some reserves and lend the rest.

 H- high power money or monetary base. It is the actual physical money printed by govt and RBI; and held in the
hands of the public.
H= C+R [ currency held by public+ reserves with banks]

 Money supply can be defined as

M= C + DD [currency held by public + dmnd dep with banks]

 High powered money acts as the base for creating demand deposits.

MONEY MULTIPLIER:

 Lower the c & r, higher the money multiplier

 Currency deposit ratio- currency held by public as a fraction of demand deposits
Ratio is affected by public preferences and seasonal patterns
 Reserve deposit ratio- reserves held by banks as fraction of their deposits
 Two parts:
o Required reserves. Called Cash Reserve Ratio
o Excess reserves. Held voluntarily.

MONEY MULTIPLIER (WITH TIME DEPOSITS)

 Here D= DD+TD
 Time deposit ratio= t = TD/DD [influenced by public preference]

FACTORS THAT INFLUENCE HIGH POWERED MONEY:

 changes in H are mainly controlled through policies and determined by the public and the banks.
 H has two components
- Money produced by govt or govt currency
- Money produced by RBI or Reserve bank money (RBM)
 RBM is the main component. So changes in RBM affects H
 Factors affecting RBM
1. Reserve bank credit to Govt
2. Reserve bank credit to banks
3. Reserve bank credit to development banks
4. Net foreign exchange assets of the reserve bank
5. Net non monetary liabilities of the reserve bank
 First four factors are directly proportional ( increase in first four leads to increase in RBM)
 Last factor is inversely proportional (increase leads to decrease in RBM)
FACTORS THAT INFLUENCE MONEY MULTIPLIER:
1. Proximate determinants- includes behavioural ratios of c,t and r
a. Decrease in c  more deposits with banks  ability lend more  increase money supply (indirect)
b. Decrease in r  more money available with banks to lend  increase in money supply (indirect)
c. Decrease in t  more money available with banks to lend  increase in money supply (indirect)

2. Ultimate determinants- those factors which influence proximate determinants.

a. c and t ratios are determined by the public’s preferences between currency, demand deposits and
time deposits
b. r ratio is concerned, while the fixation of the cash reserve ratio is a policy decision at the behest of
the central bank, the maintenance of excess reserves is an internal decision made by the banks
themselves

MONEY MULTIPLIER PROCESS:

Assumptions:
1. only demand deposits exist (D=DD)
2. Commercial bank assets take the form of loans and advances only
3. There is a large demand for bank loans at current ROI
4. There exist a fractional reserve system
5. Assume that c= 0.5 and r=0.1 for the explanation

Explanation using example:

1. Govt purchases good worth 600 from public
2. Payment is made thru cheques drawn on RBI.
3. Public keeps 200 (as c= 0.5, C/DD = ½ C:DD=1:2 C=1/3x 600= 200) and deposits 400 with banks.
4. Of this 400 dd, 40 is kept with bank as reserve and remaining is lent out
5. Money multiplier = 0.5+1 / 0.5+0.1 = 2.5
6. Money supply = 2.5 x Chang in H= 2.5 x 600= 1500

The currency deposit ratio of 0.5 means that, at all times, currency:DD in the economy should be 1:2
After currency dd ratio effect takes place, you find actuall dd. On this dd u directly apply r ratio to find reserve

CREDIT CREATION IN A SINGLE BANK MODEL:

Assumptions:
1. Only one bank
2. Only accepting DD
3. C= 0.5 and r=0.1
4. Banks assets includes reserves and loans on which they charge an interest

Explanation:
1. Govt draws cheque of 600 on RBI
2. Currency = 200 and dd= 400
3. Reserves = 40, 360 is lent out
4. This 360 is again is split in 1:2 ratio. 120 is maintained as cash and 240 as dd
5. Of this 240 dd, 24 is reserve and remaining 216 is lent out. This continues until initial deposit= total reserve
CREDIT CREATION IN A MULTIPLE BANK MODEL:

In this case you have

ignored currency
deposit ratio. Or else
you would have
again split the
deposits into 1: 2 (or
whatever ratio is
specified)

CREDIT AND DEPOSIT MULTIPLIER:

Deposit multiplier:
The deposit multiplier is the ratio of the change in deposits to the change in reserves

Credit multiplier:
Th e credit multiplier is the ratio of the change in the amount of credit to the change in reserves
Although a change in deposits can occur due to change in both the primary deposits and in the secondary deposits, a
change in credit occurs only when there is a change in the secondary deposits

CLASSICAL APPROACH

FISHER’S TRANSACTIONS APPROACH TO THE QUANTITY THEORY OF MONEY

MVT=PTT
M= Money supply
VT= Average no. of times a unit of money changes hands
PT= Average price of all kinds of market transactions
T= Sum of all transaction of goods and services
MVT= Money value of total transactions

Assumptions:
Transactions value is independent of M, Vt, Pt
Money- stock of money is determined by monetary system
Velocity- assumed to be constant cause payment practices change slowly
Price- Price is the only variable which is influenced by M

QUANTITY THEORY OF MONEY- Income version

MV=Py
M = total quantity of money in circulation
V = average number of times a unit of money changes hands
P = average level of prices of only the final goods and services
y= real income

Assuming that V is constant

Y is determined by the forces of real sector
Changes in Money causes Equi proportionate change in P

Demand for money

Demand for money in an economy is determined by value of transactions
THE CAMBRIDGE CASH BALANCE APPROACH

K gives the demand for money for every rupee of income per unit time. K depicts the proportion of money income
which the public likes to hold as money.
demand for money is a function of money income

Md= KY can be written as

Md = KPy [y= national income in real terms. Multiply it with P price, you get national income in money terms]

The above equation looks very similar to the Fisher’s equation, except for V , which represents the income
velocity (and not the transactions velocity).

DIFFERENCE BETWEEN TRANSACTIONS APPROACH AND CASH BALANCE APPROACH

transactions approach lays emphasis on the medium of exchange function of money, cash balance approach lays
emphasis on the store of value function of money and is therefore consistent with the broader meaning of money.

transactions approach lays stress on the mechanical aspects, cash balance approach is infl uenced by K, which is a
behavioural ratio

cash balance approach can be easily expressed in terms of the simple demand supply analysis whereas the same
cannot be said for the transactions approach.
CLASSICAL THEORY OF INTEREST:
According to classical theory, ROI is determined by demand and supply of capital

Demand for capital:

 Capital is demanded only for investment purpose
 It is inversely related to ROI
 For new investment, rate of return has to be compared with ROI

Supply of capital:
 Source of capital is savings
 Savings is a fn of ROI
 normal state for an economy is full employment. Hence, income cannot be taken as a variable and it cannot have
an infl uence on savings in the short run. Th erefore at the full employment level of income, saving is a direct
function of the rate of interest

Increase- rightward shift decrease- leftward shift

CRITICISM OF CLASSICAL THEORY (KEYNES BITCHING ABOUT IT):

1. No significant relationship between savings and ROI. Also, savings is affected by income level
2. Classical assumes that there can shift in investment without changing income. Which aint possible

LOANABLE FUNDS THEORY

Extension of classical theory of interest
Classical- focussed only on non monetary (real factors) LD theory- considers monetary factors as well

Assumptions:
1. Perfect mobility of funds
2. Perfect competition exists- borrower and lender are price takers
3. ROI is assumed to be constant
 4. Theory is in flow terms

Demand for loanable funds (LD):

LD= I + ΔMD
Where I= Gross investment expenditure, ΔMD= incremental demand for money

Supply of loanable funds (LS):

LS= S + DH + ΔMs
Where S= aggregate savings
DH= dishoarding of previously accumulated cash balance
ΔM= Incremental supply of money

Interest rate determination:

The horizontal distance between the S and LS curves is the sum of DH and ΔM. Th is distance increases as r increases
because while ΔM is given exogenously, DH is an increasing function of r.

Th e horizontal distance between I and LD curves is ΔMD. Th is distance increases as r decreases because ΔMD is a
decreasing function of r

the LD and LS curves intersect each other at point E. Th e equilibrium rate of interest is r ** . Th e S-I equilibrium of
the classical theory yields r * as the equilibrium rate of interest.

Critical appraisal:
Pros:
 recognizes the fact that loanable funds are demanded for purposes other than investment expenditures and also
that besides saving there exist other sources of loanable funds also.
 Classical- only real factors LD theory- both real and monetary factors
 Considers dishoarding

Cons:
 Some savings may not come through loan market
 Not all dishoardings are lent out
Etc
KEYNESIAN APPROACH