The base of this figure shows the supply of high-powered money (H), while the top of the figure shows the total stock of money supply. We derive below the expression for the size of multiplier. 3. k, that is, currency-deposit ratio of the public. From above it follows that money supply in the economy is determined by the following: 1. Thus. On the other hand, in the developing countries banking has not developed sufficiently and also people have not acquired banking habits and they prefer to make transactions in currency. Thus more high-power money (i.e., rupee currency) would come into circulation in the Indian economy. In the 1950s, Milton Friedman came out with a thesis that ‘inflation is always and everywhere a mon­etary phenomenon’. Cash Reserve Ratio of the Banks and the Deposit Multiplier: Because of fractional reserve system, with a small increase in cash reserves with the banks, they are able to create a multiple increase in total demand deposits which are an important part of money supply. When RBI purchases dollars from the foreign exchange market, it pays rupees to the sellers of foreign exchange. That is why they are called legal tender. Some economists therefore call it ‘The H Theory of Money Supply’. Hence, the dilemma faced by the Central Bank. If the Central Bank is following the policy of a fixed interest rate target, when the government resorts to borrowing to finance the budget deficit, then to prevent the rise in interest rate the Central Bank will take steps to increase the money supply in the economy. Welcome to! Money supply is one of the important macroeconomic variables. If we know the value of money multiplier we can predict how much money will change when there is a change in the amount of high-powered money. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. There must be controlled expansion of money supply if the objective of development with stability is to be achieved. Secondly, the imports of goods will increase aggregate supply of goods in the economy which will tend to lower prices. Further, though the required currency reserve-deposit ratio of banks can be easily varied by RBI, the actual currency reserve-deposit ratio cannot be so easily varied as reserves maintained by banks not only depend on minimum required cash reserve ratio but also on their willingness to hold excess reserves. This implies that our exports will be greater than imports. This situation is depicted in Fig. M4 = M3 + Total Deposits with Post Office Savings Organisation. 90 and therefore create demand deposits of Rs. It is important to note that deposit multiplier works both ways, positively when cash reserves with banks increase, and negatively when the cash reserves with the banks decline. Besides, in the open economy there are flows of capital between countries. Let us first explain sterilization operation by the Central Bank in case of deficit in current account of the balance of payments. Several definitions of money supply have been given and therefore various measures of money supply based on them have been estimated. ADVERTISEMENTS: Money supply plays a crucial role in the determination of price level and interest rate. First, the money supply refers to the total sum of money available to the public in the economy at a point of time. The value of rupee which was around Rs. The size of the money multiplier is determined by the currency ratio (Cr) of the public, the required reserve ratio (RRr) at the central bank, and the excess reserve ratio (ERr) of commercial banks. It consists of currency held by the public and total reserves held by banks. On the other hand, if time-deposits component of money supply measure M3 which serves as a store of value is increasing rapidly, it can be validly concluded that people are planning to save more and accordingly consume less. 3. If there is such a situation, there is no impact on the money supply. 16.3 where exchange rate of rupee for US dollars (Rs. M2 is a broader concept of money supply in India than M1. per US dollar) and OR and LK represent deficit in current account. The bank A will lend out Rs. However, since loans from the banks can be easily obtained against these time deposits, they can be used if found necessary for transaction purposes in this way. Money supply is one of the important macroeconomic variables. DETERMINATION OF MONEY SUPPLY IN NIGERIA ABSTRACT Money supply is one of the important macroeconomic variables. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. However, if there are sufficient net capital inflows accruing from the capital account of the balance of payments, then deficit in current account (i.e., negative NX) can be met by these capital inflows. We explain below the role of these two factors in the determination of money supply in the economy: The high-powered money which we denote by H consists of the currency (notes and coins) issued by the Government and the Reserve Bank of India. Welcome to! We explain below Reserve Bank’s analysis of sources of variation in money supply. Besides, appreciation of rupee makes imports relatively cheaper and leads to large imports of goods and materials and thereby harms our domestic manufacturing industries. June 2010; DOI: 10.13140/RG.2.1.4186.1287. But RBI has neutralized its monetary impact by mopping up liquidity of the banks through open market operations by selling them Government securities. In fact, the RBI has no fixed target for maintaining exchange rate of rupee at any level and instead its policy is to allow exchange rate of rupee to fluctuate within a band. Deposits with the banks are broadly divided into two types: demand deposits and time deposits. The sale of foreign exchange in foreign exchange market by the Central Bank causes money supply in the economy to decrease that has deflationary effect on the economy. Currency-Deposit Ratio, cr → It is the amount of currency held by people as a fraction of their holdings of demand deposits (D), Currency (C) and DD are the functions of level of income and interest rate. In this way some rupee currency had been withdrawn from the economy. As a result of large capital inflows supply curve of US dollars shifts to the right to S’S’. The impact of transactions of an open economy on the money supply can be better understood from national income identity of an open economy. Now, we take up the opposite case when there is surplus in balance of payments or when large capital inflows are taking place. Currency notes in circulation issued by the Reserve Bank of India. On the other hand, internal balance exists when the economy is in equilibrium at full employment or full productive capacity level without any inflationary pressures. The implicit assumption is that the central banks can determine the growth of money supply, and the level of money stock is the product of two components: the monetary multiplier and the monetary base. Thus, despite the fact that demand deposits and cheques through which they are operated are not legal tender, they function as money on the basis of the trust commanded by those who draw cheques on them. This implies that the supply of foreign exchange exceeds demand for it. In contrast, money multiplier takes into account these leakages of currency from the banking system and therefore measures actual increase in money supply when the cash reserves with the banks increase. Share Your PDF File To sterilize the effect of this increase in money supply RBI undertook open market operations by selling government securities to the banks which paid rupees to it. For example, if M1 is increasing firstly it can be reasonably expected that people are planning to make a large number of transactions. This difference is of crucial importance for the theory of money supply. In addition to the three items of M1, the concept of money supply M2 includes savings deposits with the post office savings banks. Since the Government and the banks produce or create money for the use by the public, the money (cash reserves) held by them are not used for transaction and speculative purposes and are excluded from the standard measures of money supply. (iii) Demand deposits of IMF and World Bank. That is, money supply is a stock concept in sharp contrast to the national income which is a flow representing the value of goods and services produced per unit of time, usually taken as a year. This will lead to the increase in money supply in the economy. 16.2 where the curve DD represents demand curve for foreign exchange (US $) and SS is the supply curve of foreign exchange (US $) at exchange rate (Rs. 100 is deposited in bank A. The definition of money supply given above represents a narrow measure of money supply and is generally described as M1. To do so more rupee currency is printed by RBI to pay for US dollars purchased by it. 16.1. It is worth noting that rapid growth in money supply in India has been due to the increase in high-powered money H, or what is also called Reserve Money (Lastly Reserve Bank of India, the money multiplier remaining almost constant. Chapter 16 Determinants of the Money Supply 561 30) If the required reserve ratio is one-third, currency in circulation is $300 billion, and checkable deposits are $900 billion, then the money supply is (a) $2700. 10 in cash from the bank and issues cheques of the remaining borrowed amount of Rs. money supply and money demand at a conceptual level in a static setting. Abstract. The effect of large capital inflows and its effect on appreciation of currency and money supply in the Indian economy is illustrated in Fig. Growth of money supply is an important factor not only for acceleration of the process of economic development but also for the achievement of price stability in the economy. Money Supply • As they are quickly and easily used for transactions, they are called transactions money. But for buying US dollars equal to EH, RBI will have to print new rupee currency to pay for US dollars. The theory of determination of money supply is based on the supply of and demand for high- powered money. This is because cash reserves with the banks must remain with them and cannot therefore be used for making payments for goods or by any commercial bank’s transactions. Suppose the balance of payments is adverse or unfavourable and therefore available foreign exchange is less than the country needs to pay for its imports, both visible and invisible. (c) $1200. Keeps it only in money, and spends the money during the month. The money multiplier which we denote by m is the ratio of total money supply (M) to the stock of high-powered money, that is, m = M/H . To prevent the high appreciation of the Indian Rupee RBI purchases US dollars from the foreign exchange market from time to time. Although Reserve Bank provides figures of the high-powered money in its analysis, it virtually clubs high-powered money with the ordinary money to calculate the total money supply in the country and therefore does not give due importance to the high-powered money as an important factor causing variation in money supply in the economy. Thus, the relationship between money supply and the high-powered money is determined by the money multiplier. On the contrary, a surplus in the balance of payments will increase the foreign exchange assets and thereby will lead to the expansion in reserve money and money supply in the economy. The FIIs started selling Indian equity and bonds and converting rupee into US dollars. however, in a dynamic context, it is difficult to assess which of these forces is mainly driving actual developments, as the determinants of money growth often affect both sides, and demand and supply interact. Measures of Money Supply/H-Theory of Money Supply/High Powered Money Supply/Determinants of Money Supply: Difference between (1) and (2) is of the second component, i.e., in (1) we have DD and in (2) we have R. To produce demand deposits banks have to maintain reserves. Therefore, RBI has to strike a balance between the two alternatives. In this way money supply in the economy increases which offsets the decrease in money supply brought about by the Central Bank when it sells foreign exchange to prevent the depreciation of the domestic currency. To avoid this adverse effect, the Central Bank buys government securities (i. e., bonds) through open market operations. TOS4. Thus, cheques make these demand deposits as a medium of exchange and therefore make them to serve as money. The Flow of Funds attack says that money supplied is determined by unfastened market operations. The private sector also borrows from the banking system when its own resources are less than its total expenditure. 80, then bank B will have only Rs. 48 per US dollar. Privacy Policy3. Accordingly, the high-powered money can be obtained as sum of currency held by the public and the part held by the banks as reserves. The above analysis of contraction in money supply as a result of use of foreign exchange reserves to meet the current account deficit is based on two assumptions. This cash reserve ratio of banks determines the magnitude of deposit multiplier. The control of money supply is an essential tool in conducting monetary policy within the monetary targeting framework. Let us make in-depth study of the importance, concept, measurement, measures, determinants, factors determining, relation with budget deficit and effect of open economy of money supply. If in equation (2) above aggregate expenditure (C + I + G) exceeds national output (Y), current account balance or NX will be negative, that is, imports will be greater than exports. This would have the effect of reducing the Reserve Money (i.e. M3 is a broad concept of money supply. TOS4. If the economy is under flexible exchange rate regime and the Central Bank of the country does not intervene at all, the exchange rate will change to OR’ and as a result deficit in current account balance will be eliminated and equilibrium restored at the new exchange rate. Therefore, money multiplier is less than the deposit multiplier. This creation of new currency for financing the deficit of the Central Government Budget is known as monetization of deficit. The value of deposit multiplier is the reciprocal of cash reserve ratio, (dm = 1/r) where dm stands for deposit multiplier.