by The money supply is all the currency and other liquid instruments in a country’s economy on the date measured. The money supply roughly includes both cash and deposits that can be used almost as easily as cash.
In macroeconomics, the money supply (or money stock) is the total value of money available in an economy at a point of time. There are several ways to define “money”, but standard measures usually include currency in circulation and demand deposits (depositors’ easily accessed assets on the books of financial institutions). The central bank of each country may use a definition of what constitutes money for its purposes.
Governments issue paper currency and coin through some combination of their central banks and treasuries. Bank regulators influence money supply available to the public through the requirements placed on banks to hold reserves, how to extend credit and other regulation.
Money supply data is recorded and published, usually by the government or the central bank of the country. Public and private sector analysts monitor changes in the money supply because of the belief that such changes affect the price levels of securities, inflation, the exchange rates, and the business cycle.
The relationship between money and prices has historically been associated with the quantity theory of money. There is strong empirical evidence of a direct relationship between the growth of the money supply and long-term price inflation, at least for rapid increases in the amount of money in the economy. For example, a country such as Zimbabwe which saw extremely rapid increases in its money supply also saw extremely rapid increases in prices (hyperinflation). This is one reason for the reliance on monetary policy as a means of controlling inflation.
The nature of this causal chain is the subject of some debate. Some heterodox economists argue that the money supply is endogenous (determined by the workings of the economy, not by the central bank) and that the sources of inflation must be found in the distributional structure of the economy.
In addition, those economists seeing the central bank’s control over the money supply as feeble say that there are two weak links between the growth of the money supply and the inflation rate. First, in the aftermath of a recession, when many resources are underutilized, an increase in the money supply can cause a sustained increase in real production instead of inflation. Second, if the velocity of money (i.e., the ratio between nominal GDP and money supply) changes, an increase in the money supply could have either no effect, an exaggerated effect, or an unpredictable effect on the growth of nominal GDP.
- Central bank money: Obligations of a central bank, including currency and central bank depository accounts
- Commercial bank money: Obligations of commercial banks, including checking accounts and savings accounts.
Effect of Money Supply on the Economy
An increase in the supply of money typically lowers interest rates, which in turn, generates more investment and puts more money in the hands of consumers, thereby stimulating spending. Businesses respond by ordering more raw materials and increasing production. The increased business activity raises the demand for labor. The opposite can occur if the money supply falls or when its growth rate declines.
Change in the money supply has long been considered to be a key factor in driving macroeconomic performance and business cycles. Macroeconomic schools of thought that focus heavily on the role of money supply include Irving Fisher’s Quantity Theory of Money, Monetarism, and Austrian Business Cycle Theory.
Historically, measuring the money supply has shown that relationships exist between it and inflation and price levels. However, since 2000, these relationships have become unstable, reducing their reliability as a guide for monetary policy. Although money supply measures are still widely used, they are one of a wide array of economic data that economists and the Federal Reserve collects and reviews.
There are several definitions of the supply of money. M1 is narrowest and most commonly used. It includes all currency (notes and coins) in circulation, all checkable deposits held at banks (bank money), and all traveler’s checks. A somewhat broader measure of the supply of money is M2, which includes all of M1 plus savings and time deposits held at banks. An even broader measure of the money supply is M3, which includes all of M2 plus large denomination, long‐term time deposits, for example, certificates of deposit (CDs) in amounts over $100,000. Most discussions of the money supply, however, are in terms of the M1 definition of the money supply.
The various types of money in the money supply are generally classified as Ms, such as M0, M1, M2 and M3, according to the type and size of the account in which the instrument is kept. Not all of the classifications are widely used, and each country may use different classifications. The money supply reflects the different types of liquidity each type of money has in the economy. It is broken up into different categories of liquidity or spendability.
M0 and M1, for example, are also called narrow money and include coins and notes that are in circulation and other money equivalents that can be converted easily to cash. M2 includes M1 and, in addition, short-term time deposits in banks and certain money market funds.1 M3 includes M2 in addition to long-term deposits. However, M3 is no longer included in the reporting by the Federal Reserve.3 MZM, or money zero maturity, is a measure that includes financial assets with zero maturity and that are immediately redeemable at par. The Federal Reserve relies heavily on MZM data because its velocity is a proven indicator of inflation.4
Money supply data is collected, recorded, and published periodically, typically by the country’s government or central bank.
Banking business. In order to understand the factors that determine the supply of money, one must first understand the role of the banking sector in the money‐creation process. Banks perform two crucial functions. First, they receive funds from depositors and, in return, provide these depositors with a checkable source of funds or with interest payments. Second, they use the funds that they receive from depositors to make loans to borrowers; that is, they serve as intermediaries in the borrowing and lending process.
When banks receive deposits, they do not keep all of these deposits on hand because they know that depositors will not demand all of these deposits at once. Instead, banks keep only a fraction of the deposits that they receive. The deposits that banks keep on hand are known as the banks’ reserves. When depositors withdraw deposits, they are paid out of the banks’ reserves. The reserve requirement is the fraction of deposits set aside for withdrawal purposes. The reserve requirement is determined by the nation’s banking authority, a government agency known as the central bank. Deposits that banks are not required to set aside as reserves can be lent to borrowers, in the form of loans. Banks earn profits by borrowing funds from depositors at zero or low rates of interest and using these funds to make loans at higher rates of interest.
A balance sheet for a typical bank is given in Table. The balance sheet summarizes the bank’s assets and liabilities. Assets are valuable items that the bank owns and consist primarily of the bank’s reserves and loans. Liabilities are valuable items that the bank owes to others and consist primarily of the bank’s deposit liabilities to its depositors. In Table, the bank’s assets (reserves and loans) total $1 million. The bank’s liabilities (deposits) total $1 million. A banking firm’s assets must always equal its liabilities.
| Assets | Liabilities | ||
| Reserves | $100,000 | Deposits | $1,000,000 |
| Loans | 90,000 | ||
You can infer from Table that the reserve requirement in this example is 10%.
Money multiplier. The amount by which bank deposits expand in response to an increase in excess reserves is found through the use of the money multiplier, which is given by the formula
Money Multiplier = 1 / Reserve Requirement
Determinants of Money Supply
- The Level of Bank Reserves:
The level of bank reserves is another determinant of the money supply. Commercial bank reserves consist of reserves on deposits with the central bank and currency in their tills or vaults. It is the central bank of the country that influences the reserves of commercial banks in order to determine the supply of money. The central bank requires all commercial banks to hold reserves equal to a fixed percentage of both time and demand deposits. These are legal minimum or required reserves.
Required reserves (RR) are determined by the required reserve ratio (RRr) and the level of deposits (D) of a commercial bank: RR-RRr’ D. If deposits amount of Rs 90 lakhs and required reserve ratio is 25 percent, then the required reserves will be 25% x 90=Rs 22.5 lakhs. If the reserve ratio is reduced to 25 per cent, the required reserves will also be reduced to Rs 22.5 lakhs.
Thus the higher the reserve ratio, the higher the required reserves to be kept by a bank, and vice versa. But it is the excess reserves (ER) which are important for the determination of the money supply. Excess reserves are the difference between total reserves (TR) and required reserves (RR): ER=TR-RR. If total reserves are Rs 90 lakhs and required reserves are Rs 25 lakhs, then the excess reserves are Rs 65 lakhs (Rs 90-25 lakhs).
When required reserves are reduced to Rs 8 lakhs, the excess reserves increase to Rs 72 lakhs. It is the excess reserves of a commercial bank which influence the size of its deposit liabilities. A commercial bank advances loans equal to its excess reserves which are an important component of the money supply. To determine the supply of money with a commercial bank, the central bank influences its reserves by adopting open market operations and discount rate policy.
Open market operations refer to the purchase and sale of government securities and other types of assets like bills, securities, bonds, etc., both government and private in the open market. When the central bank buys or sells securities in the open market, the level of bank reserves expands or contracts.
The purchase of securities by the central bank is paid for with cheques to the holders of securities who, in turn, deposit them in commercial banks thereby increasing the level of bank reserves. The opposite is the case when the central bank sells securities to the public and banks who make payments to the central bank through cash and cheques thereby reducing the level of bank reserves.
The discount rate policy affects the money supply by influencing the cost and supply of bank credit to commercial banks. The discount rate, known as the bank rate in India, is the interest rate at which commercial banks borrow from the central bank. A high discount rate means that commercial banks get less amount by selling securities to the central bank. The commercial banks, in turn, raise their lending rates to the public thereby making advances dearer for them. Thus there will be contraction of credit and the level of commercial bank reserves. Opposite is the case when the bank rate is lowered. It tends to expand credit and the consequent bank reserves.
It should be noted that commercial bank reserves are affected significantly only when open market operations and discount rate policy supplement each other. Otherwise, their effectiveness as determinants of bank reserves and consequently of money supply is limited.
- The Required Reserve Ratio:
The required reserve ratio (or the minimum cash reserve ratio or the reserve deposit ratio) is an important determinant of the money supply. An increase in the required reserve ratio reduces the supply of money with commercial banks and a decrease in required reserve ratio increases the money supply.
The RR1 is the ratio of cash to current and time deposit liabilities which is determined by law. Every commercial bank is required to keep a certain percentage of these liabilities in the form of deposits with the central bank of the country. But notes or cash held by commercial banks in their tills are not included in the minimum required reserve ratio.
But the short-term assets along with the cash are regarded as the liquid assets of a commercial bank. In India the statutory liquidity ratio (SLR) has been fixed by 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 referred to as the primary ratio. The raising of the SLR has the effect of reducing the money supply with commercial banks for lending purposes, and the lowering of the SLR tends in increase the money supply with banks for advances.
3. Public’s Desire to Hold Currency and Deposits:
People’s desire to hold currency (or cash) relative to deposits in commercial banks also determines the money supply. If people are in the habit of keeping less in cash and more in deposits with the commercial banks, the money supply will be large. This is because banks can create more money with larger deposits. On the contrary, if people do not have banking habits and prefers to keep their money holdings in cash, credit creation by banks will be less and the money supply will be at a low level.
4. High Powered Money and the Money Multiplier:
The current practice is to explain the determinants of the money supply in terms of the monetary base or high-powered money. High-powered money is the sum of commercial bank reserves and currency (notes and coins) held by the public. High-powered money is the base for the expansion of bank deposits and creation of the money supply. The supply of money varies directly with changes in the monetary base, and inversely with the currency and reserve ratios.
5. Other Factors:
The money supply is a function not only of the high-powered money determined by the monetary authorities, but of interest rates, 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 banks and the public and thus affect the money supply. Hence the money supply is not only an exogenous controllable item but also an endogenously determined item.
