Function # 1. A Medium of Exchange:

The only alternative to using money is to go back to the barter system. However, as a system of ex-change the barter system would be highly impracticable today.

For example, if the baker who supplied the green-grocer with bread had to take payment in onions and carrots, he may either not like this foodstuff or he may have sufficient stocks of them.

The baker would, therefore, have to re-sell the product which would take time and be very inconvenient. By replacing these complicated sales by the use of money it is possible to save a lot of trouble. If the baker accepts payment in money this can be spent in whatever way the baker wishes. The use of money as a medium of exchange overcomes the drawbacks of barter.

Thus, money provides the most efficient means of satisfying wants. Each consumer has a different set of wants. Money enables him (her) to decide which wants to satisfy, rank the wants in order of urgency and capacity (income) and act accordingly.

This type of system also enables specialisation to extend. Take, for example, a person who performs only a single task in a shoe factory. He has not actually produced anything himself. So what could he exchange if a barter system were in operation? With money system the problem is removed. He can be paid in terms of money and can use that money to buy what he wants.

Function # 2. A Measure of Value:

Under the barter system, it is very difficult to measure the value of goods. For example, a horse may be valued as worth five cows or 100 quintals of wheat, or a Maruti car may be equivalent to 10 two- wheelers. Thus one of the disadvantages of the barter system is that any commodity or service has a series of exchange values.

Money is the measuring rod of everything. By acting as a common denominator it permits everything to be priced, that is, valued in terms of money. Thus, people are enabled to com pare different prices and thus see the relative values of different goods and services.

This serves two basic purposes:

(1) Households (consumers) can plan their expenditure and

(2) Business people can keep records of income and costs in order to work out their profit and loss figures.

Function # 3. A Store of Value (Purchasing Power):

A major disadvantage of using commodities — such as wheat or salt or even animals like horses or cows — as money is that after a time they deteriorate and lose economic value. They are, thus, not at all satisfactory as a means of storing wealth. To realise the problems of saving in a barter economy let us consider a farmer. He wanted to save some wheat each week for future consumption. But this would be of no use to him in his old age because the ‘savings’ would have gone off.

Again, if a coal miner wanted to set aside a certain amount of coal each week for the same purpose, he would have problems of finding enough storage space for all his coal. By using money, such problems can be overcome and people are able to save for the future. Modern form of money (such as coins, notes and bank deposits) permits people to save their surplus income.

Thus money is used as a store of purchasing power. It can be held over a period of time and used to finance future payments. Moreover, when people save money, they get the assurance that the money saved will have value when they wish to spend it in the future. However, this statement holds only if there is no severe inflation (or deflation) in the country.

In other words, it is quite obvious that money can only act effectively as a store of value if its own value is stable. If, for example, most people feel that their savings would become worthless very soon, they would spend them at once and save nothing. For the last few years the value (or the purchasing power) of money has been falling in India. Yet in the short run—for day-to-day purposes—money has sufficient stability of value to serve quite well as a store of value.

Function # 4. The Basis of Credit:

Money facilitates loans. Borrowers can use money to obtain goods and services when they are needed most. A newly married couple, for example, would need a lot of money to completely furnish a house at once. They are not required to wait for, say ten years, so as to be able to save enough money to buy costly items like cars, refrigerators, T.V. sets, etc.

Function # 5. A Unit of Account:

An attribute of money is that it is used as a unit of account. The implication is that money is used to measure and record financial transactions as also the value of goods or services produced in a country over time. The money value of goods and services produced in an economy in an accounting year is called gross national product. According to J. R. Hicks, gross national product is a collection of goods and services reduced to a common basis by being measured in terms of money.

Function # 6. A Standard of Postponed Payment:

This is an extension of the first function. Here again money is used as a medium of exchange, but this time the payment is spread over a period of time. Thus, when goods are bought on hire-purchase, they are given to the buyer upon payment of a deposit, and he then pays the remaining amount in a number of instalments.

Under the barter system this type of transaction could involve problems. Imagine a farmer buying a video-recorder and agreeing to pay for it in terms of a fixed amount of wheat each week for a certain number of weeks. After a few weeks the seller of the video recorder might have more than enough wheat.

Yet he will have to receive more wheat in the coming weeks. If money had been used, the seller could then use it to buy whatever he wanted, whether it is wheat or something else—now or in future. In other words, the use of money permits postponement of spending from the present to some future occasion.

In a modern economy, most transactions (buying and selling) are made on the basis of credit. For example, it is possible to purchase consumer durables such as T.V. sets or washing machines on hire-purchase; houses may be purchased by means of L.I.C. or H.D.F.C. loan; most business dealings permit payment in the future for goods delivered now; and employees wait for a month or a week to receive their wages and salaries. Thus, the use of money permits the members of society to defer their spending from the present to some future date.

We, therefore, see that a money system clearly has advantages over a barter system. But what is money? Note the first five words in our definition – “anything which is generally acceptable.” We use notes and coins to buy things but can do so only as long as shopkeepers and traders are prepared to accept those notes and coins in payment for the goods they are selling.

If all sellers decided that they would no longer accept these notes and coins, then these would cease to be money. If they decided instead to accept chair legs as money, then we would have to use chair legs which we would have to use when buying something! This example, of course, is rather ridiculous but what it points out is that anything can be money as long as it is generally acceptable as such

Quantity theory of money

To examine how is the general price level determined? Why does price level change? Classical or pre- Keynesian economists answered all these questions in terms of quantity theory of money.

In its simplest form, it states that the general price level (P) in an economy is directly dependent on the money supply (M);

P = f (M)

If M doubles, P will double. If M is reduced to half, P will decline by the same amount. This is the essence of the quantity theory of money. Though the theory was first stated in 1586, it received its full-fledged popularity at the hands of Irving Fisher in 1911. Later, an alternative approach was given by a group of Cambridge economists. However, the basic conclusion of these two theories is same price level varies directly with and proportionally to money supply.

Assumptions:

The classical quantity theory of money is based on two fundamental assumptions: First is the operation of Say’s Law of Market. Say’s law states that, “Supply creates its own demand.” This means that the sum of values of all goods produced is equivalent to the sum of values of all goods bought.

Thus, by definition, there cannot be deficiency of demand or underutilisation of resources. There will always be full employment in the economy. Second is the assumption of full employment that follows from the Say’s Law.

1. Quantity Theory of Money— Fisher’s Version:

Like the price of a commodity, value of money is determined by the supply of money and demand for money. In his theory of demand for money, Fisher attached emphasis on the use of money as a medium of exchange. In other words, money is demanded for transaction purposes.

As a truism, in a given time period, total money expenditure is equal to the total value of goods traded in the economy. In other words, national expenditure, i.e., the value of money, must be identically equal to national income or total value of the goods for which money is exchanged, i.e.,

MV = ∑ piqj = PT …. (4.1)

Where

M = total stock of money in an economy;

V = velocity of circulation of money, that is, the number of times a unit of money changes its hand;

Pi = prices of individual goods;

∑P = p1q1 + p2q2 + … + pnqn are the prices and outputs of all individual goods;

qi = quantities of individual goods transacted;

P = average or general price level or index of prices;

T = total volume of goods transacted or index of physical volume of transactions.

This equation is an identity that always holds true: It tells us that the total stock of money used for transactions must equal to the value of goods sold in the economy. In this equation, supply of money consists of nominal quantity of money multiplied by the velocity of circulation.

The average number of times that a unit of money changes its hand is called the velocity of circulation of money. The concept that provides the link between M and P x T is also called the velocity of money. V is, thus, defined as total expenditure, P x T, divided by the amount of money, M, i.e.

V = P x T/M

If P x T in a year is Rs. 5 crore and the quantity of money is Rs. 1 crore then V = 5. This means that a unit of money is spent 5 times in buying goods and services in the economy. Thus, the supply of money or the total expenditure on national income is MV. On the other hand, total value of all transactions or money demand comprises P multiplied by T.

Fisher assumed fixity in V in the short run. V is determined by (i) the payment habits of the people, (ii) the nature of the banking system, and (iii) general factors (e.g., density of population, rapidity of transportation). As far as T is concerned, Say’s Law suggests that it would remain fixed because of full employment.

With V and T constant, the above identity is modified as:

MV = PT … (4.2)

Or P = V/T x M … (4.3)

Where the bar signs over the heads of ‘V’ and ‘T’ indicates that these two are fixed. It now follows that an increase in M leads to an equi-proportional increase in P.

The stock of money, thus, determines the price level. People hold money more than their need for transactions when money supply increases. Holding of money is useless. So they spend money. This additional expenditure, given full employment, raises the price level.

Obviously, a rise in the price level means an increase in the value of transactions and, hence, demand for money rises. The process will continue until the equality between demand for and supply of money is re-established.

Fisher’s cash transaction version can be extended by including bank deposits in the definition of money supply. Now money supply comprises not only legal tender money, M but also bank money, M’. This bank money has also a stable velocity of circulation, V’.

Thus the above equation can be written as:

Assuming V, V’, T and the ratio of M and M’ constant, an increase in M and M’, say by 5 p.c., will cause P to rise also by the same percentage.

It is, however, not easier to measure the number of transactions T. Let us replace T by Y. Thus P. Y is the nominal income or output where Y is the total income. Now the quantity theory equation becomes: PY = MV. This is known as the ‘income version’ of quantity theory of money.

2. Quantity Theory of Money: Cambridge Version:

An alternative version, known as cash balance version, was developed by a group of Cambridge economists like Pigou, Marshall, Robertson and Keynes in the early 1900s. These economists argue that money acts both as a store of wealth and a medium of exchange. Here, by cash balance and money balance we mean the amount of money that people want to hold rather than savings.

According to Cambridge economists, people wish to hold cash to finance transactions and for security against unforeseen needs. They also suggested that an individual’s demand for cash or money balances is proportional to his income. Obviously, larger the incomes of the individual, greater is the demand for cash or money balances.

Thus, the demand for cash balances is specified by:

Md = kPY …(4.6)

where Y is the physical level of aggregate or national output, P is the average price and k is the proportion of national output or income that people want to hold. Let us assume that the supply of money, MS’ is determined by the monetary authority, i.e.,

MS = M …(4.7)

Equilibrium requires that the supply of money must equal the demand for money, or

k and Y are determined independently of the money supply. With k constant given by the transaction demand for money and Y constant because of full employment, increase or decrease in money supply leads to a proportional

increase and decrease in price level. This conclusion holds for Fisherian version also. Note that Cambridge ‘k’ and Fisherian V are reciprocals of one another, that is, 1/k is the same as V in Fisher’s equation.

The classical relationship between money supply and price level can be illustrated in terms of Fig. 4.1. This diagram is interesting in the sense that it first establishes the relationship between money supply and national output or national income below the full employment stage (YF). For this relationship, the origin ‘O’ is important.

Now the relationship between money supply and price level after the full employment stage can be established assuming O’ as the origin. Before the attainment of full employment state (YF), an increase in money supply (from OM1 to OM2 and to OYF) causes national income (shown by the steep output curve) to rise more rapidly than the price level.

By utilising its resources efficiently and fully, an economy can increase its output level by increasing the volume of investment consequent upon an increase in money supply. Since there is a limit to output expansion due to full employment (i.e., beyond which output will not increase), an increase in money supply from (M3 to M4) will cause price level to rise from (P3 to P4) proportionally (shown in the upper panel).

For stability in price level money supply should grow in proportion to increases in output.

Limitations:

This theory has been criticised on several grounds:

(i) Inoperative below Full Employment:

It is alleged that the quantity theory of money comes into its own only during period of full employment of resources. Assuming constancy in V, V’, T, Y, etc., a change in money supply will bring about a change in price level. During the period of full employment, T or Y remains unchanged. During such a time, even if money supply rises, T or Y will not change.

On the other hand, price level will rise. But, in reality, full employment of resources is a rare possibility. What we find in reality is unemployment or underemployment of resources. During underemployment an increase in money supply will tend to raise output level and, hence, T, but not P. So, quantity theory of money breaks down when resources remain at full employment.

(ii) V, T, etc., do not Remain Fixed:

Secondly, in a dynamic economy V, V’, T, the ratio of M to M’ never remain constant. In such an economy, a change in any of the variables may cause a change in price level, even if money supply does not change. In this sense, these are not independent variables, although the authors of this theory assumed quantity of money as independent of other elements of the equation.

(iii) It is Identity, That is, Always True:

Thirdly, Fisher’s equation is an identity. MV and PT are always equal. In fact, the quantity theory of money is a hypothesis and not an identity which is always true.

(iv) Aggregate Demand/Expenditure, and not M, Influences Price Level:

Fourthly, Keynes argued that price level in an economy is not influenced by money supply. The im-portant determinant of money supply is the income level and the total expenditure of the country. According to Keynes, an increase in money supply is tantamount to an increase in effective demand.

After attaining the stage of full employment, an increase in effective demand which is the sum of consumption expenditure, investment expenditure and government expenditure (i.e., C + I + G) will raise the price level, but not proportionately.

(v) Too much Emphasis on Money Supply:

Fifthly, change in price level is caused by various factors, besides money supply. For example, an increase in cost of production has an important bearing on the price level. For in stance, an increase in wage rate following a revision in the pay scale of employees or an increase in the price of raw materials (say, hike in the price of petroleum products) will definitely push the price level up, whether the economy stays on or below the full employment level. The quantity theory attaches too much importance on money supply.

(vi) M Influences P via Interest Rate:

Sixthly, the classical theory establishes a direct and proportional relationship between money supply and price level. Critics say that the relationship is not a direct one. Fisher ignored the influence of the rate of interest on the price level. Supply of bank money or credit money is influenced largely by the interest rate.

It is argued that the increase in money supply first affects the rate of interest which influences total output and price level in the ultimate analysis. The casual relationship is: Change in the stock of money → change in interest rate change in investment → change in in come, employment and output → change in general prices.

Conclusion:

Despite these criticisms, the quantity theory of money has certain merits. Whenever money supply rose abnormally in the past in an economy, inflationary situation developed there. May not be the relationship a proportional one, but excessive increase in money supply leads to inflation.

In the 1950s, Milton Friedman came out with a thesis that ‘inflation is always and everywhere a monetary phenomenon’. This Friedman words are enough to establish the essence of quantity theory of money inflation is largely caused by the excessive growth of money supply and by nothing else.

Concept of Money Supply and Its Measurement:

By money supply we mean the total stock of monetary media of exchange available to a society for use in connection with the economic activity of the country.

According to the standard concept of money supply, it is composed of the following two elements:

1. Currency with the public,

2. Demand deposits with the public.

Before explaining these two components of money supply two things must be noted with regard to the money supply in the economy. First, the money supply refers to the total sum of money available to the public in the economy at a point of time. 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.

Secondly, money supply always refers to the amount of money held by the public. In the term public are included households, firms and institutions other than banks and the government. The rationale behind considering money supply as held by the public is to separate the producers of money from those who use money to fulfil their various types of demand for money.

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. This separation of producers of money from the users of money is important from the viewpoint of both monetary theory and policy.

Let us explain the two components of money supply at some length:

Currency with the Public:

In order to arrive at the total currency with the public in India we add the following items:

1. Currency notes in circulation issued by the Reserve Bank of India.

2. The number of rupee notes and coins in circulation.

3. Small coins in circulation.

It is worth noting that cash reserves with the banks have to be deducted from the value of the above three items of currency in order to arrive at the total currency with the public. 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.

It may further be noted that these days paper currency issued by Reserve Bank of India (RBI) are not fully backed by the reserves of gold and silver, nor it is considered necessary to do so. Full backing of paper currency by reserves of gold prevailed in the past when gold standard or silver standard type of monetary system existed.

According to the modern economic thinking the magnitude of currency issued should be determined by the monetary needs of the economy and not by the available reserves of gold and silver. In other

developed countries, since 1957 Reserve Bank of India follows Minimum Reserve System of issuing currency.

Under this system, minimum reserves of Rs. 200 crores of gold and other approved securities (such as dollars, pound sterling, etc.) have to be kept and against this any amount of currency can be issued depending on the monetary requirements of the economy.

RBI is not bound to convert notes into equal value of gold or silver. In the present times currency is inconvertible. The word written on the note, say 100 rupee notes and signed by the governor of RBI that ‘I promise to pay the bearer a sum of 100 rupees’ is only a legacy of the past and does not imply its convertibility into gold or silver.

Another important thing to note is that paper currency or coins are fiat money, which means that currency notes and metallic coins serve as money on the bases of the fiat (i.e. order) of the Government. In other words, on the authority of the Government no one can refuse to accept them in payment for the transaction made. That is why they are called legal tender.

Demand Deposits with the Public:

The other important component of money supply is demand deposits of the public with the banks. These demand deposits held by the public are also called bank money or deposit money. Deposits with the banks are broadly divided into two types: demand deposits and time deposits. Demand deposits in the banks are those deposits which can be withdrawn by drawing cheques on them.

Through cheques these deposits can be transferred to others for making payments from whom goods and services have been purchased. Thus, cheques make these demand deposits as a medium of exchange and therefore make them to serve as money. It may be noted that demand deposits are fiduciary money proper.

Fiduciary money is one which functions as money on the basis of trust of the persons who make payment rather than on the basis of the authority of Government. 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. They are money as they are generally acceptable as medium of payment.

Bank deposits are created when people deposit currency with them. But far more important is that banks themselves create deposits when they give advances to businessmen and others. On the basis of small cash reserves of currency, they are able to create a much larger amount of demand deposits through a system called fractional reserve system which will be explained later in detail.

In the developed countries such as USA and Great Britain deposit money accounted for over 80 per cent of the total money supply, currency being a relatively small part of it. This is because banking system has greatly developed there and also people have developed banking habits.

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. However in India after 50 years of independence and economic development the proportion of bank deposits in the money supply has risen to about 50 per cent.

Four Measures of Money Supply:

Several definitions of money supply have been given and therefore various measures of money supply based on them have been estimated. First, different components of money supply have been distinguished on the basis of the different functions that money performs. For example, demand deposits, credit card and currency are used by the people primarily as a medium of exchange for buying goods and services and making other transactions.

Obviously, they are money because they are used as a medium of exchange and are generally referred to as M1. Another measure of money supply is M 3 which includes both M1 and time deposits held by the public in the banks. Time deposits are money that people hold as store of value.

The main reason why money supply is classified into various measures on the basis of its functions is that effective predictions can be made about the likely effects on the economy of changes in the different components of money supply. For example, if M1 is increasing firstly it can be reasonably expected that people are planning to make a large number of transactions.

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.

Therefore, it is believed that for monetary analysis and policy formulation, a single measure of money supply is not only inadequate but may be misleading too. Hence various measures of money supply are prepared to meet the needs of monetary analysis and policy formulation.

Recently in India as well as in some developed countries, four concepts of money supply have been distinguished. The definition of money supply given above represents a narrow measure of money supply and is generally described as M1.

From April 1977, the Reserve Bank of India has adopted four concepts of money supply in its analysis of the quantum of and variations in money supply. These four concepts of measures of money supply are explained below.

Money Supply M1 or Narrow Money:

This is the narrow measure of money supply and is composed of the following items:

Ml = C + DD + OD

Where, C = Currency with the public

DD = Demand deposits with the public in the commercial and cooperative banks.

OD = Other deposits held by the public with Reserve Bank of India.

The money supply is the most liquid measure of money supply as the money included in it can be easily used as a medium of exchange, that is, as a means of making payments for transactions.

Currency with the public (C) in the above measure of money supply consists of the following:

(i) Notes in circulation.

(ii) Circulation of rupee coins as well as small coins

(iii) Cash reserves on hand with all banks.

Note that in measuring demand deposits with the public in the banks (i.e., DD), inter-bank deposits, that is, deposits held by a bank in other banks, are excluded from this measure.

In the other deposits with Reserve Bank of India (i.e., OD) deposits held by the Central and State Governments and a few others such as RBI Employees’ Pension and Provident Funds are excluded.

However, these other deposits of Reserve Bank of India include the following items:

(i) Deposits of Institutions such as UTI, IDBI, IFCI, NABARD etc.

(ii) Demand deposits of foreign Central Banks and Foreign Governments.

(iii) Demand deposits of IMF and World Bank.

It may be noted that other deposits of Reserve Bank of India constitute a very small proportion (less than one per cent).

Money Supply M2:

M2 is a broader concept of money supply in India than M1. In addition to the three items of M1, the concept of money supply M2 includes savings deposits with the post office savings banks. Thus,

M2 = M1 + Savings deposits with the post office savings banks.

The reason why money supply M2 has been distinguished from M1 is that saving deposits with post office savings banks are not as liquid as demand deposits with commercial and cooperative banks as they are not chequable accounts. However, saving deposits with post offices are more liquid than time deposits with the banks.

Money Supply M3 or Broad Money:

M3 is a broad concept of money supply. In addition to the items of money supply included in measure M1, in money supply M3 time deposits with the banks are also included. Thus

M3= M1+ Time Deposits with the banks.

It is generally thought that time deposits serve as store of value and represent savings of the people and are not liquid as they cannot be withdrawn through drawing cheque on them. 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. Further, they can be withdrawn at any time by forgoing some interest earned on them.

It may be noted that recently M3 has become a popular measure of money supply. The working group on monetary reforms under the chairmanship of late Prof. Sukhamoy Chakravarty

recommended its use for monetary planning of the economy and setting target of the growth of money supply in terms of M3.

Therefore, recently RBI in its analysis of growth of money supply and its effects on the economy has shifted to the use of M3 measure of money supply. In the terminology of money supply employed by the Reserve Bank of India till April 1977, this M3 was called Aggregate Monetary Resources (AMR).

Money Supply M4:

The measure M4 of money supply includes not only all the items of M3 described above but also the total deposits with the post office savings organisation. However, this excludes contributions made by the public to the national saving certificates. Thus,

M4 = M3 + Total Deposits with Post Office Savings Organisation.

Let us summaries the four concepts of money supply as used by Reserve Bank of India in the following tabular form:

Determinants of Money Supply:

In order to explain the determinants of money supply in an economy we shall use M, concept of money supply which is the most fundamental concept of money supply. We shall denote it simply by M rather than M1. This concept of money supply is composed of currency held by the public (Cp) and demand deposits with the banks (D). Thus

M = Cp + D …(1)

Where, M = Total money supply with the public

Cp = Currency with the public

D = Demand deposits held by the public

The two important determinants of money supply as described in equation (1) are (a) the amounts of high-powered money which is also called Reserve Money by the Reserve Bank of India and (b) the size of money multiplier.

We explain below the role of these two factors in the determination of money supply in the economy:

1. High-Powered Money (H):

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. A part of the currency issued is held by the public, which we designate as Cp and a part is held by the banks as reserves which we designate as R.

A part of these currency reserves of the banks is held by them in their own cash vaults and a part is deposited in the Reserve Bank of India in the Reserve Accounts which banks hold with RBI. 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. Thus

H = Cp+ R …(2)

Where, H = the amount of high-powered money

Cp = Currency held by the public

R = Cash Reserves of currency with the banks.

It is worth noting that Reserve Bank of India and Government are producers of the high-powered money and the commercial banks do not have any role in producing this high-powered money (H). However, commercial banks are producers of demand deposits which are also used as money like currency.

But for producing demand deposits or credit, banks have to keep with themselves cash reserves of currency which have been denoted by R in equation (2) above. Since these cash reserves with the banks serve as a basis for the multiple creation of demand deposits which constitute an important part of total money supply in the economy, it provides high-powered-ness to the currency issued by Reserve Bank and Government.

A glance at equations (1) and (2) above will reveal that the difference in the two equations, one describing the total money supply and the other high-powered money, is that whereas in the former, demand deposits (D) are added to the currency held by the public, in the latter it is cash reserves (R) of the banks that are added to the currency held by the public.

In fact, it is against these cash reserves (R) that banks are able to create a multiple expansion of credit or demand deposits due to which there is large expansion in money supply in the economy. The theory of determination of money supply is based on the supply of and demand for high- powered money.

Some economists therefore call it ‘The H Theory of Money Supply’. However, it is more popularly called ‘Money-multiplier Theory of Money Supply’ because it explains the determination of money supply as a certain multiple of the high- powered money. How the high-powered money (H) is related to the total money supply is graphically depicted in Fig. 16.1.

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. It will be seen that the total stock of money supply (that is, the top) is determined by a multiple of the high-powered money (H). It will be further seen that whereas currency held by the public (Cp) uses the same amount of high-powered money, that is, there is one-to-one relationship between currency held by the public and the money supply.

In sharp contrast to this, bank deposits (D) are a multiple of the cash reserves (R) of the banks which are part of the supply of high-powered money. That is, one rupee of high- powered money kept as bank reserves gives rise to much more amount of demand deposits. Thus, the relationship between money supply and the high-powered money is determined by the money multiplier.

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 . The size of money multiplier depends on the preference of the public to hold currency relative to deposits, (that is, ratio of currency to deposits which we denote by K) and banks’ desired cash reserves ratio to deposits which we call r. We explain below the precise multiplier relationship between high-powered money and the total stock of money supply.

It follows from above that if there is increase in currency held by the public which is a part of the high-powered money with demand deposits remaining unchanged, there will be a direct increase in the money supply in the economy because this constitutes a part of the money supply.

If instead currency reserves held by the banks increase, this will not change the money supply immediately but will set in motion a process of multiple creation of demand deposits of the public in the banks. Although banks use these currency reserves held by the public which constitutes a part of the high- powered money to give more loans to the businessmen and thus create demand deposits, they do not affect either the amount of currency or the composition of high-powered money. The amount of high-powered money is fixed by RBI by its past actions. Thus, changes in high-powered money are the result of decisions of Reserve Bank of India or the Government which owns and controls it.

2. Money Multiplier:

Money multiplier is the degree to which money supply is expanded as a result of the increase in high-powered money. Thus

m = M/H

Rearranging we have, M = H.m …(3)

Thus money supply is determined by the size of money multiplier (m) and the amount of high- powered money (H). 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.

Change in the high-powered money is decided and controlled by Reserve Bank of India, the money multiplier determines the extent to which decision by RBI regarding the change in high-powered money will bring about change in the total money supply in the economy.

Size of Money Multiplier:

Now, an important question is what determines the size of money multiplier. It is the cash or currency reserve ratio r of the banks (which determines deposit multiplier) and currency-deposit ratio of the public (which we denote by k) which together determines size of money multiplier. We derive below the expression for the size of multiplier.

From equation (1) above, we know that total money supply (M) consists of currency with the public (Cp) and demand deposits with the banks. Thus

From above it follows that money supply in the economy is determined by the following:

1. H, that is, the amount of high-powered money, which is also called reserve money

2. r, that is, cash reserve ratio of banks (i. e., ratio of currency reserves to deposits of the banks)

This cash reserve ratio of banks determines the magnitude of deposit multiplier.

3. k, that is, currency-deposit ratio of the public.

From the equation (4) expressing the determinants of money supply, it follows that money supply will increase:

1. When the supply of high-powered money (i.e., reserve money) H increases;

2. When the currency-deposit ratio (k)’ of the public decreases; and

3. When the cash or currency reserves-deposit ratio of the banks (r) falls.

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. The ratio of change in total deposits to a change in reserves is called the deposit multiplier which depends on cash reserve ratio.

The value of deposit multiplier is the reciprocal of cash reserve ratio, (dm = 1/r) where dm stands for deposit multiplier. If cash reserve ratio is 10 per cent of deposits, then dm = 1/0.10 = 10. Thus deposit multiplier of 10 shows that for every Rs. 100 increase in cash reserves with the banks, there will be expansion in demand deposits of the banks by Rs. 1000 assuming that no leakage of cash to the public occurs during the process of deposit expansion by the banks.

Currency-Deposit Ratio of the Public and Money Multiplier:

However, in the real world, with the increase in reserves of the banks, demand deposits and money supply do not increase to the full extent of deposit multiplier. This is for two reasons. First, the public does not hold all its money balances in the form of demand deposits with the banks.

When as a result of increase in cash reserves, banks start increasing demand deposits, the people may also like to have some more currency with them as money balances. This means during the process of creation of demand deposits by banks, some currency is leaked out from the banks to the people.

This drainage of currency to the people in the real world reduces the magnitude of expansion of demand deposit and therefore the size of money multiplier. Suppose the cash reserve ratio is 10 per cent and cash or currency of Rs. 100 is deposited in bank A. The bank A will lend out Rs. 90 and therefore create demand deposits of Rs. 90 and so the process will continue as the borrowers use these deposits for payment through cheques to others who deposit them in another bank B.

However, if borrower of bank A withdraws Rs. 10 in cash from the bank and issues cheques of the remaining borrowed amount of Rs. 80, then bank B will have only Rs. 80 as new deposits instead of Rs. 90 which it would have if cash of Rs. 10 was not withdrawn by the borrower. With these new deposits of Rs. 80, bank B will create demand deposits of Rs. 72, that is, it will lend out Rs. 72 and keep Rs. 8 as reserves with it (80x 10/100 = 8).

The drainage of currency may occur during all the subsequent stages of deposit expansion in the banking system. The greater the leakage of currency, the lower will be the money multiplier. We thus see that the currency-deposit ratio, which we denote by k, is an important determinant of the actual value of money multiplier.

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. That is, when there is a decrease in currency reserves with the banks, there will be multiple contraction in demand deposits with the banks.

Excess Reserves:

In the explanation of the expansion of demand deposits or deposit multiplier we have assumed that banks do not keep currency reserves in excess of the required cash reserve ratio. The ratio r in the deposit multiplier is the required cash reserve ratio fixed by Reserve Bank of India.

However, banks may like to keep with themselves some excess reserves, the amount of which depends on the extent of liquidity (i.e. availability of cash with them) and profitability of making investment and rate of interest on loans advanced to business firms. Therefore, the desired reserve ratio is greater than the statutory minimum required reserve ratio. Obviously, the holding of excess reserves by the banks also reduces the value of deposit multiplier.

Conclusion:

Theory of determination of money supply explains how a given supply of high-powered money (which is also called monetary base or reserve money) leads to multiple expansion in money supply through the working of money multiplier. We have seen above how a small increase in reserves of currency with the banks leads to a multiple expansion in demand deposits by the banks through the process of deposit multiplier and thus causes growth of money supply in the economy.

Deposit multiplier measures how much increase in demand deposits (or money supply) occurs as a result of a given increase in cash or currency, reserves with the banks depending on the required cash reserve ratio (r) if there are no cash drainage from the banking system. But in the real world drainage of currency does take place which reduces the extent of expansion of money supply following the increase in cash reserves with the banks.

Therefore, the deposit multiplier exaggerates the actual increase in money supply from a given increase in cash reserves with the banks. 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.

The money multiplier can be defined as increase in money supply for every rupee increase in cash reserves (or high-powered money), drainage of currency having been taken into account. Therefore, money multiplier is less than the deposit multiplier.

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.

The money supply in a country can be changed by Reserve Bank of India by undertaking open market operations, changing minimum required currency reserve-deposit ratio, and by varying the bank rate. The main source of growth in money supply in India is creation of credit by RBI for Government for financing its budget deficit and thus creating high-powered money.

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.

Lastly, an important noteworthy point is that though money multiplier does not show much variation in the long run, it can change significantly in the short run causing large variations in money supply. This unpredictable variation in money multiplier in the short run affecting money supply in the economy prevents the Central Bank of a country from controlling exactly and precisely the money supply in the economy.

Determination of demand for money

The demand for money comes from the desire to hold liquid assets of which money is the only perfect example. It may be noted that money is not demanded for its own sake but because it can be used to purchase economic goods and services.

Keynes argued that there are three motives for holding money. First, individuals will demand money to finance their daily purchases of goods and services. This is known as the transactions motive. Secondly, people will demand money as a contingency against unforeseen expenditures. This is known as the precautionary motive. Thirdly, people will hold money as a store of wealth.

This is known as the speculative motive. In particular, people hold money for speculative purposes because they are unsure about the returns from the alternative financial assets in which they could hold their wealth, i.e., bonds. The returns from holding bonds have two components, viz., the interest payments and the possibility of a capital gain or loss.

If the expected loss is greater than the interest payments the net return is negative and the individual concerned will hold no bonds, only money. Bond prices are inversely related to the interest rate and, therefore, if an individual expects a sharp rise in the interest rate, this is the same as expecting a corresponding sharp fall in bond prices and again he will hold only money.

Keynes supposed at the aggregate level that individuals hold a wide variety of different views about expected rates of interest in future and therefore as the current rate of interest fell more and more people would expect that eventually it would rise again — the price of bonds would fall — and therefore more people would hold only money.

In this manner, Keynes argued that in aggregate the demand for money for speculative purposes, L(r), would be inversely related to the interest rate, r In contrast, the amount of money demanded for transactions and precautionary purposes, kPY, was determined by the individuals’ level of income Y and the general price level (P).

Thus, in Keynes’ theory the demand for money is expressed as:

Md = kPY + L (r)

where Md is the total demand for money, kPY is transactions and precautionary demand and L(r) is speculative demand. Here Y is national income, P is the price level and k is the fraction or proportion of income held in the form of liquid balance (0<k<1).

If V increases, k remaining the same, people will require more money to spend. Likewise, if P increases people will require more money to buy the same amount of goods and services. Here, L is liquidity preference (or speculative demand) which is a function of the rate of interest (r) L varies inversely with r. vanes inversely with r.

An individual’s preference for liquidity, money, therefore arises because of his uncertainty about the exact point in time when he will need money – the precautionary motive -and his uncertainty about future interest rates – the speculative motive. Liquidity preference in the Keynesian analysis is therefore largely a function of uncertainty.

The demand for money refers to the desire to hold money in liquid form as an alternative to purchasing income-earning assets like bonds. Money can be used for any purpose immediately and therefore people desire to hold money either as cash in hand or in the form of readily withdrawable demand deposits in banks. J.M. Keynes calls this desire as “liquidity preference”.

According to Keynes, people hold money for three purposes, viz., transactions, precautionary and speculative.

The motives lying behind liquidity preference (or why people desire to hold money) can be analysed as follows:

(1) The transactions motive:

Liquid balances are necessary to bridge the interval between receipt of income and outlay. Income is received periodically. A man who gets his wages once a month must keep enough cash in his hands or in his current account to carry on his day-to-day purchases between one pay day and another.

The same considerations apply to businesspeople and industrialists. They also must keep some money in hand for their day-to-day transactions. The amount of money, required for this purpose, depends upon the general level of business activity.

(2) The precautionary motive:

Liquid balances are required to be kept in hand to provide for emergencies like sickness or accident. Everyone likes to keep some money in hand by way of precaution against such contingent liabilities and unforeseen expenses.

(3) The speculative motive:

Liquid balances are held with the expectation of finding better uses for them in the future. Opportunities for the purchase of goods or of bonds, on favourable terms, may come any time and everyone likes to keep some money at hand to avail him of such opportunities. Money kept as a store of wealth comes within this category. (Keynes)

Balances held from the transactions or the precautionary motives are little affected by the rate of interest. But those held for the speculative purposes are particularly sensitive to it.

The demand for money depends on three main factors: national income, the price level and the rate of interest. Transactions demand and precautionary demand vary directly with the first two factors but speculative demand for money varies inversely with the market rate of interest.

Monetary Equilibrium:

Monetary equilibrium occurs when the demand for money equals the supply of money. In fact, the rate of interest does the job of equating the quantity of money demanded to the available supply,

i.e., it does the job of producing monetary equilibrium. In Fig. 3 we see how the rate of interest ensures monetary equilibrium.

The money supply is fixed by the central bank at Mo. Since (by assumption) the money supply does not change with the rate of interest the supply curve of money Mo is completely inelastic — a vertical straight line. The curve LP is the demand curve for money or the liquidity preference curve. It slopes downward from left to right because of the speculative component. Speculative demand for money varies inversely with the market rate of interest.

So, the LP curve shows how the total demand for money varies with the rate of interest and it is drawn for a specific level of national income. Constancy of national income implies fixed demand for money for transactions and precautionary purposes. The money market reaches equilibrium at the interest rate r0, where the LP and the M0 curves intersect. At this rate of interest, households and business firms are just willing to hold all of the money that is available to be held.

If, however, the actual rate of interest deviates from its equilibrium level (r0) there will be disequilibrium in the money market. If it falls below the equilibrium level (r1) there will be excess demand for money. People will satisfy this demand by selling bonds. This excess demand for money implies excess supply of bonds. This, in its turn, will depress the price of bonds.

And, a fall in the price of bonds implies a rise in the rate of interest. The converse is also true. If the rate of interest goes up (to r2) there will be excess supply of money. This implies excess demand for bonds. The price of bonds will rise as a consequence.

So, this is equivalent to a fall in the market rate of interest. Thus, we see that the rate of interest rises when there is excess demand for money and falls when there is an excess supply of money. So the condition for monetary equilibrium is that the rate of interest will be such that the community, as a whole, is just willing to hold the existing stock of money.

Credit creation

Demand deposits are an important constituent of money supply and the expansion of demand deposits means the expansion of money supply. The entire structure of banking is based on credit. Credit basically means getting the purchasing power now and promising to pay at some time in the future. Bank credit means bank loans and advances.

A bank keeps a certain part of its deposits as a minimum reserve to meet the demands of its depositors and lends out the remaining to earn income. The loan is credited to the account of the borrower. Every bank loan creates an equivalent deposit in the bank. Therefore, credit creation means expansion of bank deposits.

The two most important aspects of credit creation are:

Liquidity – The bank must pay cash to its depositors when they exercise their right to demand cash against their deposits.

Profitability – Banks are profit-driven enterprises. Therefore, a bank must grant loans in a manner which earns higher interest than what it pays on its deposits.

The bank’s credit creation process is based on the assumption that during any time interval, only a fraction of its customers genuinely need cash. Also, the bank assumes that all its customers would not turn up demanding cash against their deposits at one point in time.

Basic Concepts of Credit Creation

Bank as a business institution – Bank is a business institution which tries to maximize profits through loans and advances from the deposits.

Bank Deposits – Bank deposits form the basis for credit creation and are of two types:

Primary Deposits – A bank accepts cash from the customer and opens a deposit in his name. This is a primary deposit. This does not mean credit creation. These deposits simply convert currency money into deposit money. However, these deposits form the basis for the creation of credit.

Secondary or Derivative Deposits – A bank grants loans and advances and instead of giving cash to the borrower, opens a deposit account in his name. This is the secondary or derivative deposit. Every loan crates a deposit. The creation of a derivative deposit means the creation of credit.

Cash Reserve Ratio (CRR) – Banks know that all depositors will not withdraw all deposits at the same time. Therefore, they keep a fraction of the total deposits for meeting the cash demand of the depositors and lend the remaining excess deposits. CRR is the percentage of total deposits which the banks must hold in cash reserves for meeting the depositors’ demand for cash.

Excess Reserves – The reserves over and above the cash reserves are the excess reserves. These reserves are used for loans and credit creation.

Credit Multiplier – Given a certain amount of cash, a bank can create multiple times credit. In the process of multiple credit creation, the total amount of derivative deposits that a bank creates is a multiple of the initial cash reserves.

Credit creation by a single bank

There are two ways of analyzing the credit creation process:

Credit creation by a single bank

Credit creation by the banking system as a whole

In a single bank system, one bank operates all the cash deposits and cheques. The process of creating credit is explained with the hypothetical example below:

Let’s assume that the bank requires to maintain a CRR of 20 percent.

If a person (person A) deposits 1,000 rupees with the bank, then the bank keeps only 200 rupees in the cash reserve and lends the remaining 800 to another person (person B). They open a credit account in the borrower’s name for the same.

Similarly, the bank keeps 20 percent of Rs. 800 (i.e. Rs. 160) and advances the remaining Rs. 640 to person C.

Further, the bank keeps 20 percent of Rs. 640 (i.e. Rs. 128) and advances the remaining Rs. 512 to person D.

This process continues until the initial primary deposit of Rs. 1,000 and the initial additional reserves of Rs. 800 lead to additional or derivative deposits of Rs. 4,000 (800+640+512+….).

Adding the initial deposits, we get total deposits of Rs. 5,000. In this case, the credit multiplier is 5 (reciprocal of the CRR) and the credit creation is five times the initial excess reserves of Rs. 800.

Multiple Credit Creation by the Banking System

The banking system has many banks in it and it cannot grant loans in excess of the cash it creates. When a bank creates a derivative deposit, it loses cash to other banks.

The loss of deposit of one bank is the gain of deposit for some other bank. This transfer of cash within the banking system creates primary deposits and increases the possibility for further creation of derivative deposits. Here is an illustration to explain this process better:

As explained above, the initial deposit of Rs. 1,000 with bank A leads to a creation of total deposits of Rs. 5,000.

Limitations of Credit Creation

While banks would prefer an unlimited capacity for creating credit to increase profits, there are many limitations. These limitations make the process of creating credit non-profitable. Therefore, a bank continues to create additional credit as long as:

There is a negligible chance of the loans turning into bad debts

The interest rate that banks charge on loans and advances is greater than the interest that the bank gives to depositors for the money deposited in the bank.

Hence, we can say that the limitations of credit creation operate through shifts in the balance between liquidity and profitability.

The factors that affect the creation of credit are:

The capacity of banks to create credit.

The willingness of the banks to create credit

Also, the demand for credit in the market.

Capacity to create credit is a matter of:

The availability of cash deposits with banks

The factors which determine their cash deposit ratio

As regards the demand for credit:

The demand must exist in the market

Creditworthy borrowers (to avoid bad debts)

The amount of loan granted should not exceed the paying capacity of the borrower

Leakages

If the banks are unwilling to utilize their surplus funds for granting loans, then the economy is headed towards recession

If the public withdraws cash and holds it with themselves, then it reduces the bank’s power to create credit.

Monetary policy:

Monetary policy is a central bank's actions and communications that manage the money supply. The money supply includes forms of credit, cash, checks, and money market mutual funds. The most important of these forms of money is credit. Credit includes loans, bonds, and mortgages.

Monetary policy increases liquidity to create economic growth. It reduces liquidity to prevent inflation. Central banks use interest rates, bank reserve requirements, and the number of government bonds that banks must hold. All these tools affect how much banks can lend. The volume of loans affects the money supply

Three Objectives of Monetary Policy

Central banks have three monetary policy objectives. The most important is to manage inflation. The secondary objective is to reduce unemployment, but only after controlling inflation. The third objective is to promote moderate long-term interest rates.

The U.S. Federal Reserve, like many other central banks, has specific targets for these objectives. It wants the core inflation rate to be around 2%. Beyond that, it prefers a natural rate of unemployment of between 3.5% and 4.5%.

Types of Monetary Policy

Central banks use contractionary monetary policy to reduce inflation. They reduce the money supply by restricting the volume of money banks can lend. The banks charge a higher interest rate, making loans more expensive. Fewer businesses and individuals borrow, slowing growth.

Central banks use expansionary monetary policy to lower unemployment and avoid recession. They increase liquidity by giving banks more money to lend. Banks lower interest rates, making loans cheaper. Businesses borrow more to buy equipment, hire employees, and expand their operations. Individuals borrow more to buy more homes, cars, and appliances. That increases demand and spurs economic growth.

Monetary Policy vs. Fiscal Policy

Ideally, monetary policy should work hand-in-glove with the national government's fiscal policy. It rarely works this way. Government leaders get re-elected for reducing taxes or increasing spending. As a result, they adopt an expansionary fiscal policy. To avoid inflation in this situation, the Fed is forced to use a restrictive monetary policy.

For example, after the Great Recession, Republicans in Congress became concerned about the U.S. debt. It exceeded the debt-to-GDP ratio of 100%. As a result, fiscal policy became contractionary just

when it needed to be expansionary. To compensate, the Fed injected massive amounts of money into the economy with quantitative easing.

Monetary Policy Tools

All central banks have three tools of monetary policy in common. First, they all use open market operations. They buy and sell government bonds and other securities from member banks. This action changes the reserve amount the banks have on hand. A higher reserve means banks can lend less. That's a contractionary policy. In the United States, the Fed sells Treasury’s to member banks.

The second tool is the reserve requirement, in which the central banks tell their members how much money they must keep on reserve each night. Not everyone needs all their money each day, so it is safe for the banks to lend most of it out. That way, they have enough cash on hand to meet most demands for redemption. Previously, this reserve requirement has been 10%. However, effective March 26, 2020, the Fed has reduced the reserve requirement to zero.

When a central bank wants to restrict liquidity, it raises the reserve requirement. That gives banks less money to lend. When it wants to expand liquidity, it lowers the requirement that gives members banks more money to lend. Central banks rarely change the reserve requirement because it requires a lot of paperwork for the members.

The third tool is the discount rate. That's how much a central bank charges members to borrow funds from its discount window. It raises the discount rate to discourage banks from borrowing. That action reduces liquidity and slows the economy. By lowering the discount rate, it encourages borrowing. That increases liquidity and boosts growth.

In the United States, the Federal Open Market Committee sets the discount rate a half-point higher than the fed funds rate. The Fed prefers banks to borrow from each other.

Most central banks have many more tools. They work together to manage bank reserves.

The Fed has two other major tools it can use. It is most well-known is the Fed funds rate. This rate is the interest rate that banks charge each other to store their excess cash overnight. The target for this rate is set at the FOMC meetings. The fed funds rate impacts all other interest rates, including bank loan rates and mortgage rates.

The Fed, as well as many other central banks, also uses inflation targeting. It sets expectations that the banks want some inflation. The Fed’s inflation goal is 2% for the core inflation rate. That encourages people to stock up now since they know prices are rising later. It stimulates demand and economic growth.

When inflation is lower than the core, the Fed is likely to lower the fed funds rate. When inflation is at the target or above, the Fed will raise its rate.

The Federal Reserve created many new tools to deal with the 2008 financial crisis. These included the Commercial Paper Funding Facility and the Term Auction Lending Facility. It stopped using most of them once the crisis ended.

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