MGT1114:

Principles of Macroeconomics

Module 5: Behavioural
Foundations

Lecture title: Money supply,

money multiplier and money
creation
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 Theory of Money supply
• The total money that serves as medium of exchange and
store of value is supplied mainly by two sources—the central
bank (the RBI in India) and the commercial banks.
• Banks do not create their own money. They add to the
money supply through their system of borrowing and
lending.
• The money supplied by the two sources—central bank and
commercial banks—do not work independently.
• Nor does the money supplied by each of them circulate
as independent and identifiable units.
• The money supply from both the sources is, in fact,
interlinked.
• The high-power money multiplies itself in the process of
monetary transactions between the people and the banks.
• The analysis of how money supplied by the central bank
multiplies itself in the process of monetary transactions
results into the theory of money supply.
• The theory of money supply makes a distinction between the
two concepts of money supply:
• the ordinary money or the stock of money (M) and the
high-power money (H), also called ‘base money’.
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• The ordinary money includes the currency held by the public and the demand deposits, both used as
medium of exchange and store of value.
• The concept of ‘ordinary money’ is similar to M1 used by the RBI.
• The ordinary money (M) is defined as M = C + DD
• where, C = currency with the public, and DD = demand deposits with banks.
• The high-power money (H) is defined as: H = C + R
• where, C = currency with the public, and R = cash reserves with the central bank and with other
banks themselves.
• The cash reserves (R ) with the commercial banks have two components:
(i) statutory reserve requirement, also called statutory reserve ratio (SRR) which banks are required
to maintain with the central bank, the RBI; and
(ii) excess reserve which commercial banks need to maintain as ‘cash in hand’ or ‘cash in vault’, in
excess of SRR, to meet the demand for cash by the depositors. The ratio of excess reserve to
deposits is based on bank’s payment need and past experience.

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 • The total supply of money (M) in a country is determined by a money
Money multiplier multiplier, given the supply of the high-power money (H).
• M = mH
• Money multiplier is the rate at which high power money or ‘reserve
money’ gets multiplied to make the supply of total ordinary or broad
money.
• Thus, the general method of measuring money multiplier (m)—used also
by the RBI — is
• m = M/H
• The analysis of the relationship between M and H, given in the above Eq,
is the central theme of the theory of money supply.
• The high-power money (H ) is the basic money and it forms the basis of
money creation through monetary transactions between the public and
the banks.
• By assumption, H is policy-determined: it is determined exogenously by
the central bank of the country.
• Given the supply of H, the determination of M, i.e. the stock of ordinary
money, depends entirely on the value of money multiplier (m).
• The theory of money supply explains how the value of m, the money
multiplier, is determined.

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 • The different countries, different authors use different variables to
explain the method of measuring money multiplier.
• In general, there are two widely used methods of measuring the
money multiplier (m).
• While some authors consider only a ‘uniform deposit’ or demand
deposits (DD) in working out the money multiplier, some other
authors consider both demand deposit (DD), and time deposit (TD).
Approaches to the • Incidentally, RBI uses the second method.
Determination of • The RBI measures money multiplier (m) as

Money Multiplier (m)

• where M3 is ‘broad money’; M0 is ‘reserve money’; and C is

‘currency in circulation.
• Since both M3 and M0 are subject to variation, money multiplier
(m) also keeps changing. For instance, during 2006-08, money
multiplier varied between 4.5 and 5.
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 The Determinants of
Money Multiplier

(a) The proximate or immediate factors, and

(b) The ultimate factors

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 (a) The proximate or immediate factors

• The money multiplier (m) can be expressed as

• The proximate or immediate determinants of money multiplier include

• (i) currency-deposit ratio (c),
• (ii) reserve-deposit ratio (r),
• (iii) time and demand deposit ratio, i.e., TD/DD ratio (t).
• The role of c, r and t in determining the value of the money multiplier can be described,
respectively, as follows.

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(i) Currency-deposit ratio (c) and money multiplier:
• The higher the currency-deposit ratio (c), the smaller the money multiplier (m), and vice
versa.
• It means that if public prefers to hold a high proportion of H in the form of cash (C) and a
smaller proportion of it as deposits (D), then the ability of the banks to create secondary
deposits and credit will be reduced to the extent it reduces the value of ‘m’.
• Consequently, m will be lower.
• For example, suppose c = 0.3, r = 0.1, and t = 0.2. The substitution of these values in the
above Eq. gives m = 3.1. If c rises to 0.5, other factors remaining the same, then m decreases
to 2.42. On the contrary, if public decides to hold only a small part of H as cash, m will be
higher.

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ii. Reserve-deposit ratio (r) and money multiplier:
• The role of reserve-deposit ratio (r) is more obvious.
• It appears in the denominator of the money-multiplier formula.
• Therefore, the higher the reserve-deposit ratio (r), the lower the value of money multiplier
(m).
• In simple words, if banks’ reserve requirement (RR) increases, their ability to create deposit
and credit decreases and, therefore, the value of m decreases.
• For example, recall that if c = 0.3, r = 0.1 and t = 0.2, then m = 3. And, if the central bank
raises RR so that r increases from 0.1 to 0.15, other factors remaining the same, then m falls
to 2.7.

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iii. Time-deposit ratio (t) and money multiplier
• The role of time-deposit ratio (t), that is, the ratio of time deposit to demand deposit, in the
determination of money multiplier is like that of the reserve-deposit ratio (r).
• That is, the higher value of t, the smaller the value of m.
• That is, if public decides to increase the ratio of time deposit (TD) to demand deposit (DD),
then the value of m decreases.
• Recall the example again if in one period c = 0.3, r = 0.1 and t = 0.2, then m = 3.1. Suppose
now that the public decides to increase the time-deposit ratio (r) from 0.2 to 0.3, then the
value of m decreases to 2.38.

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(b) The ultimate factors
• The proximate determinants of the money multiplier, c, r and t, are merely the numerical ratios that
appear in the multiplier formula. The value of these factors depends on certain other factors.
• The factors that determine the value of c, r and t are the ultimate factors.
• They are ultimate in the sense that they arise out of the working of the economic system and the
decisions taken by the Central Bank, the public and the commercial banks.
• Let us look at the factors that are behind their decision-making.
1. As regards the reserve-deposit ratio (r), it depends on (i) the statutory reserve ratio (SRR), and (ii) the excess
reserve ratio (ER).
• The SRR is determined by the central bank, in view of the monetary needs of the country.
• The excess reserve ratio (ER) is determined by the banks themselves in view of demand for cash by the
depositors.
2. As regards the determination of c and t, it is the public which decides the proportion of H to hold as
currency, as demand deposit and as time deposit.
• The decision regarding these factors are taken on the basis of (a) the level of income, (b) the interest rate,
(c) the development level of the banking system, (d) banking habit of the people, and also (e) the black
money held by the public— it is very high in the context of the Indian economy.
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Money creation

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