Determinants of Money Supply –
Money supply is composed of currency held by the public (CP) and demand deposits of the public with the banks (D).
M = CP + D
M = Total money supply with the public
CP = Currency with the public
D = Demand deposits of the public with the banks
The two important determinants of the money supply are
(a) the amounts of high powered money which is also called Reserve Money by the RBI and
(b) the size of the money multiplier.
High Powered Money (H) –
The high powered money consists of the currency notes and coins issued by the government and RBI. A part of this currency is held by the public and a part of is held by the banks as reserves. A part of these currency reserves of the banks is held by them and a part is deposited in the RBI in the Reserve Accounts which banks hold with RBI.
H = CP + D
H = the amount of high powered money
CP = currency held by the public
D = cash reserves of currency with the banks
An important point is that RBI and government are the producers of the high powered money and the commercial banks do not have any role in producing high powered money, but commercial banks are the producers of demand deposits which is also used as money. But for producing demand deposits they have to keep reserves of currency with them according to the cash reserve ratio fixed by the RBI or by the government. These cash reserve serves as a basis for the creation of the demand deposits which are an important part of the total money supply in the economy. It provides high poweredness to the currency issued by the RBI and government.
The theory of determination of the money supply is based on the demand for and supply of high powered money. It is also called ‘The H Theory of Money Supply’.
It is also called ‘Money Multiplier Theory of Money Supply’ because it explains the determination of money supply as a certain multiple of the high powered money.
Money Multiplier –
Money multiplier is the ratio total money supply (M) to the stock of high powered money. or
Money multiplier shows the degree to which money supply can be expanded as a result of the increase in high powered money.
Money multiplier = m = M/H
or M = H.m
The size of the money multiplier depends on the preference of the public to hold currency relative to deposits (denoted by k) and bank’s desired cash reserves ratio to deposits (denoted by r).
Money supply is determined by the size of money multiplier (m) and the amount of high powered money (H).
Size of Money Multiplier –
Size of the money multiplier is determined by the cash reserve ratio (r) of the banks and currency deposit ratio of the public (k).
Money supply (M) consists of currency with the public (CP) and demand deposits of the public with the banks (D).
M = CP + D
Public holds an amount of currency in a certain ratio of demand deposits with the banks. This currency deposit ratio is denoted by k.
CP = kD
M = kD + D = (k+1)D
High powered money = H = CP + R
R = Currency Reserves which the banks keep as a certain ratio of their deposits and is called cash reserve ratio. It is denoted by r.
So, R = rD
And, CP = kD
Then, H = kD + rD = (k+r)D
Money multiplier is the ratio of total money supply to the high powered money,
So, m = M/H = [(k+1)D] / [(k+r)D]
Money multiplier = m = M/H = (1+k)/(r+k)
So, M = H [(1+k)/(r+k)]
r = reserve ratio of the banks
k = cash deposit ratio of the public
Money supply is determined by the high powered money times the money multiplier which is equal to the (1+k)/(r+k).
Factors determining the money supply in the economy are H, r and k.
Cash Reserve Ratio and the Deposit Multiplier –
Deposit multiplier is the ratio of change in total deposits to a change in reserves which depends on the cash reserve ratio.
The value of deposit multiplier is the reciprocal of the cash reserve ratio.
dm = 1/r
dm = Deposit Multiplier
r = cash reserve ratio
For example, if r is 10% ,
Then, dm = 1/0.10 = 10
So the deposit multiplier of 10 shows that for every ₹ 1000 increase in cash reserves, will expand the demand deposits of the banks by ₹ 10000 assuming that there is no leakage of cash to the public during the process of deposit expansion by the banks.