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Subject ECONOMICS

Paper No and Title 11 MONEY AND BANKING

Module No and Title 2 Theories of money supply

Module Tag ECO_P11_M2

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3.MONEY MULTIPLIER APPROACH
3.1 Ordinary money and High powered money

3.2 The H Theory of money supply.

3.3 Criticism of the money multiplier approach

4. STRUCTURAL APPROACH

4.1 Balance Sheet Approach

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4.2 Goodhart’s general equilibrium model

5. Summary

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1. Learning Outcomes
After studying this module, you shall be able to

· Know how the supply of money is determined

· Learn about the various theories of its determination
· Identify factors that affect the money supply in an economy
· Analyse the process of money supply determination in the different approaches.

2. Introduction

Money supply process

Until the late 1960s, the supply of money was treated as a policy variable determined by the
monetary authorities. Monetary research in the theory of money supply made substantial
advances thereafter, which clarified the analytical underpinnings of the money supply process.

The supply of money is determined jointly by the public authority, banks and the public. In
this determination the monetary authority plays an active anddominant role, but that of the public
and banks cannot be ignored or taken for granted. Understanding this role is essential for a
successful policy of monetary control.

In the context of developing countries and emerging market economies, there are essentially
two main approaches to money supply determination: the money multiplier approach with its
foundation in the works of Friedman and Schwartz (1963) and Cagan (1965) and the balance-
sheet or structural approach. The money multiplier approach focuses on the relationship between
money stock M and reserve money H and through the money multiplier m to the public’s
preference between currency, demand deposits and time deposits and to the banks holding of
reserves as a proportion of aggregate deposits/liabilities, while the structural approach favours
analysis of individual items in the balance sheet of the consolidated monetary sector in explaining
variations in money stock. The difference between them reflects the division between monetarists
and non-monetarists.

3. MONEY MULTIPLER APPROACH

3.1 Ordinary Money and High Powered Money

As a preliminary to the study of the Theory of Money Supply, it is essential to understand

the distinction between two kinds of money. (a) Ordinary Money (M) and (b) High
Powered Money (H)

The alternative empirical measures of money discussed in the previous

modules were all measures of ordinary money M..Here we will define money narrowly as
M=C+DD+OD thatis, sum of currency and demand deposits of banks including the RBI
held by the public and since other deposits of the RBI are less than 1% of the total money

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supply, we ignore OD in the future discussion, ThisM is

the money produced by the RBI, government,and the banking system and held by the
public.

M=C+DD(1)

High powered money (H) is the money produced by the RBI, Government and held by
the public and banks. It is also called Reserve or Base Money. H= C + R + OD that is,H
is the sum of (a) Currency held by the public C (b) Cash Reserves of banks R and (c)
other Deposits of the RBI OD.Since OD are 1% of total H,we ignore it and hence

H= C + R (2)

This definition of H is by its use or holders, not by its producers RBI and the
Government.

Comparing equation (1) and (2) we find that C is common to both M and H, but while M
has DD, H has this difference is of crucial importance in the theory of Money Supply.
This is because of the presence of bankswho are the producers ofDD, which is counted as
money at par with C.But to be able to produceDD, banks have to maintain R which is a
part of H produced only by the monetary authority and not by banks themselves. In a
fractional reserve banking system, DD are certain multiple of which is a component of
H.This makes H High powered compared to M.It serves as the base for multiple creation
of Which is a part of M.This is the reason why H is called base Money. At any point of
time only R lends the high poweredness of H, but C has the potential to become high
powered the moment it is converted into DD by the public and the banks reserves would
increase equivalently..

3.2 The H Theory of Money –Supply

The H theory of money supply is so called because H is the dominant factor determining
money supply. Since money multiplier is the outcome of this approach, it is also called
the Money Multiplier Approach. We discuss this in the demand supply framework. We
initially assume supply of H to be policy determined given exogenously to the public and
banks.

Hs = H (3)

The demand for H comes from the public demand for currency C and banks demand for
Reserves R.The demand for C and DD, the two components of ordinary money are
affected by the same set of factors like level of income and the rate of interest, and is
therefore correlated. Thatis, demand for C is a proportional function of DD

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Cd=c DD (4)

Where c is the desired currency deposit ratio of the public. It is assumed to be a

behavioral constant.

Moving to the banks demand for reserves R, We first look at the components of R

R =RR + ER (5)

RR are the reserves which the scheduled banks are required to hold statutorily as balances
with the RBI .The RBI stipulates the cash reserve which can vary between 3 to 15% of
the total demand and time liabilities of a bank.The banks have no choice about the
holding of these reserves

ER is all reserves in excess of RR.Banks are free to hold them as cash on hand or vault
cash or even as balances with the RBI.These reserves are held voluntarily by the banks as
a certain proportion of Total Liabilities of the bank. They are held by the banks for
transactions, precautionary and speculative purposes

Dividing throughout equation (5) by total Deposits D we have

Rd/D = RR/D +ERd/D which can be represented as

r =RR + e(6)

that is, reserve ratio ( r )is equal to the statutory cash reserve ratio( rr )plus the excess
reserve ratio( e )

Rd = r. D (7)

The total reserves R are a certain proportion r of the total deposits of banks, Here r is
called the reserve deposit ratio.

D =DD + TD (8)

Now Bank Deposits are of two kinds DD or demand deposits which are treated as a part
of money in the narrow definition.TD are near money, and a part of the broader definition
of money. The choice of division of D between DD and TD is done by the Public.
Wehypothesis that TD is an increasing proportional function of DD.whereit is the ratio of
TDto DD.

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TDd = t.DD (9)

Now, fromeqn (7) and (8) we have,

D = (1+ t) DD

From eq(7) and (9) and substituting for (r) from equation (6)

Rd=(rr+e)(1+t) DD (9)

From eq(2) and (9)

Hd = [c+ (rr +e) (1+t)]DD which gives us in equilibrium,Hd = Hs

DD =1H(10)
C+ (rr + e) (1+t)

Where1 is the value of the deposit multiplier

c+(rr + e )(1+t)

Now from eqn (1) and (10) we have the key equation in the H Theory of Money supply

M =I+c
------------------ H (11)
c+ (rr +e) (1+t)

This makes the supply of money a function of H and the behavioral ratios c, rr, e, t where the

expression1+c is the value of the narrow money multiplier

--------------------
c + (rr + e) (1+t)

This can be representedas m1 and hence we can represent the money supply equation as

M=m( )H (12)

Here the money multiplier is treated as a behaviouralconstant as a function of thevariables c, t, rr

and e and the money multiplier systematically responds to a set of impulses.

In this general formulation, the money multiplier approach suggests that determinants of the
money stock can be classified into two broad groups: (1) those that affect the reserve money, and
(2) those that affect the money multiplier.

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3.3 Criticism of the money multiplier approach.

The critics of the money multiplier theory have the following arguments

1) The money multiplier approach is based on an identity, an analytically convenient

tautology, offering just a description of movements in money stock, rather than a
behavioral theory of its determination.

2) In its general form M =m ( ) H It is an equilibrium condition rather than a money

supply function and process involved is rather mechanical. The only facets of portfolio
choice considered are those of the public in the determination of desired C/DD and
desired TD/DD ratio and banks in the determination of R/D ratio. This is inadequate as
the analysis does not involve or require any interest changes

3) The theory of Money stock determination should be treated as a branch of a general

theory of portfolio adjustment in response to relative price or yield changes. By taking
the reserve money as given. The money multiplier identity short circuits this approach.

4) The reserve money is taken as exogenously given (whose values are considered to be
determined outside the system under consideration), fixed by monetary authorities, and
no steps are taken to examine the factors determining its level As a matter of fact level of
reserve money is a target (control variables whose values the authorities attempt to set)
rather than an exogenous variable. To treat the policy targets as exogenous variables
implies that the authorities do not alter their control variables in response to the system.
The money multiplier identity obscures rather than illuminates the fundamental nature of
the process of money stock determination

There is essentially, adivergence of views regarding the usefulness of the money

multiplier which could be traced to division between the monetarists and the non-
monetarists. The former argue that monetary authorities can exercise effective control
over the stock of money while the latter question the feasibility of this exercise. The
controversybetween them boilsdown to 3 issues

1) Which of the variables in equation (11) can be controlled by the monetary authorities?

2) If some of the variables are not controllable, can monetary authorities offset influences
of such variables by using instruments at their disposal?

3) Are the behavioral functions explaining these variables stable and predictable?

According to the non-monetarists, not only are most of the variables entering the equation
endogenous, the behavioral functions explaining the determinants are also unstable and

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Since the monetary authorities in the developing economies do not have potent policy
instruments to offset the impact of changes in these variables on money stock and hence
are not in a position to effectively control the process of money stock determination.

The monetarists agree that both real and financial sectors of the economy exert influence
on the money stock, but the behavioral patterns of the public and the banks are
sufficiently stable and predictable so as to permit the monetary authorities to control the
money stock. The issue is therefore empirical and country specific, depending on the
stage of financial development of the economy.

4. STRUCTURAL APPROACH

4.1 Balance sheet approach

Table 1

Balance sheet of the consolidated Banking Sector

Liabilities Assets

(A)Monetary Liabilities (A) Financial Assets

1-Currency with the public 1-Net Bank Credit to Government

2-Deposit liabilities of Banks 2-Bank Credit to Commercial sector

3-Other deposits with the RBI 3-Net foreign exchange assets of Banking
Sector

4-Government’s Currency Liabilities to

the Public

(B)Non monetary Liabilities (B) Other Assets

This approach is based on the balance sheet of the consolidated banking sector rather than of
thecentral bank as in the money multiplier approach.

Since broad money M3 comprises the monetary liabilities of the consolidated banking sector, it
follows from the asset side that:

M3=Net Bank credit to govt.

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+Bank credit to commercial sector

+Net foreign exchange assets of the banking sector

+govts currency liabilities to the public

–net non monetary liabilities of the Banking Sector.

The essence of the balance sheet approach lies in the examinations of variations in money stock
through analysis of credit creation by the consolidated banking system through credit given to
government and the commercial sector and movements in the foreign exchange asset holding etc.
By focusing on a dis aggregated analysis of the consolidated banking sector, the balance sheet
approach obviates the need for a mechanistic appraisal of the money multiplier.

4.2Goodhart’s general equilibrium model

This provides a behavioural Theory of money supply determination the model identifies
four critical issues influencing the determination of money stock;

(1) The size of the public sector Deficit

(2) Market reactions to the authorities open market operations
(3) The elasticity of substitution between foreign and domestic assets
(4) Interest elasticity of the demand for bank credit

It works with a flow of funds identity:

PSD = OMO +NMD +ECF – MAT + Δ H

Where PSD = public Sector deficit

OMO = outcome of operations in marketable debt

NMD =outcome of transactions in non marketable debt

MAT = use of funds to pay off maturing debt

ECF = finance obtained from, or required for accommodating external currency

Flows

Δ H = change in reserve money

The flow of funds identity is combined with a set of behavioural equations in the model
covering the factors (2), (3),(4) above in a general equilibrium framework.The
determination of money stock is seen as a process of general portfolio adjustment in

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response to relative interest rate changes. The time

path of the process depends on the relevant speeds of
adjustment of various sectors to relative price changes, rather than the mechanistic
process embedded in the money multiplier approach.

This approach may have conceptual superiority, but it is more relevant in a developed
and fully liberalized financial system and not for an emerging market economy like India.

5. Summary
In This module we discussed the following.

· The money supply process

· Difference between M and H
· H Theory of money supply
· Criticism of the money multiplier Theory
· The balance sheet approach as an alternative to the money multiplier theory
· Goodhart’s general equilibrium model.

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