Saturday, August 22, 2009

Supply of Money and its Demerits

The term ‘the supply of money’ is synonymous with such terms as “money stork”, “Stock of money”, “money supply” and “quantity of money”. The supply of money at any moment is the total amount of money in the economy. There are three alternative views regarding the definition or measures of money supply. The most common view is associated with the traditional and Keynesian thinking which stresses the medium of exchange function of money. According to this view, money supply is defined as currency with the public and demand deposits with commercial banks. Demand deposits are savings and current accounts of depositors in commercial banks. They are the liquid form of the money because depositors can draw cheques for any amount lying in their accounts and bank has to make immediate payment on demand. Demand deposits with commercial banks plus currency with the public are together denoted M1, the money supply. This is regarded as a narrower definition of the money supply.
The second definition is broader and is associated with the modern quantity theorists headed by Friedman. Friedman defines the money supply at any moment of time as “literally the number of dollars people are carrying around in their pockets, the number of dollars they have to their credit at banks or dollars they have to their credit at banks in the form of demand deposits and also commercial bank time deposits”. Time deposits are fixed deposits of customers in commercial bank. Such deposits earn a fixed rate of interest varying with the time period for which the amount id deposited. Money can be with drain before the expiry of that period by paying a penal rate of interest to the bank. So time deposits possess liquidity and are included in the money supply by Friedman. Thus the definition includes M2 plus time deposits of commercial banks in the supply of money. This under definition is characterised as M2 in America and M3 in Britain. It stresses the store of value function of money or what Friedman says “a temporary abode of purchasing power”.
The third definition is the broadest and is associated with Gurley and show. They include in the supply of money M2, plus deposits of savings banks building societies, ban associations and deposits of other credit and financial institutions.
The choice between these alternative definitions of the money supply depends on two considerations. One “a particular choice of definition may facilitate of blur the analysis of the various motives of holding cash” and two form the point of view of monetary policy. An appropriate definition should include the area over which the money authorises can have direct influence. If these two criteria are applied, none of three definitions is wholly satisfactory.
The first definition of money supply may be analytically better because M1 is a sure medium of exchange. But M1 is an inferior store of value because it earns no rate of interest, as is earned by time deposits.
The second definition that includes time deposits (M2) in the supply of money is less satisfactory analytically because “in a highly developed financial structure it is important to consider separately motives for holding means of payment and time deposits”. Unlike demand deposits, time deposits are not a perfect liquid form of money. This is because amount lying in them can be withdrawn immediately by cheques. Normally it cannot be withdrawn before the due date of expiry of the deposit. Thus time deposits lack perfect liquidity and cannot be included in money supply. But his definition is more appropriate from the point of view of monetary policy because the central bank can exercise control over wider area that includes both demand and time deposits held by commercial banks.
The third definition of money supply that includes M2 plus deposits of non bank financial institution is unsatisfactory on the both criteria. Firstly they do not serve the medium of exchange function of money. Secondly they almost remain outside the area of the control of central bank. The only advantage they possess is that they are highly liquid store of value. Despite this merit deposits of non bank financial institutions are not included in the definition of money supply.
From the above discussion we can conclude that the quantity supplied of all the kinds of money put together will make the supply of money in the country.
There are two theories of determinants of the money supply. According to the first view, the money supply is determined exogenously by the central bank. The second view holds that the money supply is determined endogenous by changes in the economic activity which affect people’s desire to hold currency relative to deposits, the rate of interest etc. Thus the determinants of money supply are both exogenous and endogenous which can be described broadly as the minimum cash reserve ratio, the level of bank reserves and the desire of people to hold to hold currency relative to deposits.
1. The Required Reserve Ratio: The required reserve ratio of the minimum cash reserve ratio of the reserve deposit ratio is an important determinant of money supply. An increase in the required reserve ratio reduces the supply of money with commercial banks and a decrease in required reserve ratio increases the money supply. The RR1 is the ratio of cash to current and time deposit liabilities which is determined by law. Every commercial bank is required to keep a certain percentage of these liabilities in the form of deposits with the central bank of the country. But notes or cash held by commercial banks in their tills are not included in the minimum required reserve ratio.
2. The level of Bank Reserves: The level of bank reserves is another determinant of the money supply. Commercial banks reserves consist of reserves on deposits with the central bank and currency in their tills or values. It is the central bank of the country that influences the reserves of commercial banks in order to determine the supply of money. The central bank requires all commercial banks to hold reserves equal to fixed percentage of both time and demand deposits. These are legal minimum or required reserves. Required reserves (RR) are determined by the required reserve ratio (RRr) and the level of deposit (D) of a commercial bank RR = RRr × D. If deposits amount of Rs. 20 lacs and required reserve ratio is 20 percent, then the required reserves will be 20% × 80 = Rs. 16 Lacs. If the reserve ratio is reduced to 10 percent, the required reserves will also be reduced to Rs. 8 lacs. Thus higher the reserve ratio the higher the reserves to be kept by bank and vice versa. But it is excess reserves (ER) which are important for the determination of money supply. Excess reserves are the difference between total reserves (TR) and required reserves (RR) ER = TR – RR. It is excess reserves of a commercial bank which influence the size of its deposits liabilities. A commercial bank advances loans equal to its excess reserves which are an important component of money supply. To determine the supply of money with a commercial bank, the central bank influences its reserves by adopting open market operation and discount rate policy.
3. Public’s Desire to Hold Currency and Deposits: Peoples desire to hold currency relative to deposits in commercial banks also determines the money supply. If people are in habit of keeping less in cash and more in deposits with commercial banks, the money will be large. This is because banks can create more money with larger deposits. On the contrary, if people do not have banking habits and prefer to keep their money holdings in cash, credit creation by banks will be less and the money supply will be at a low level.
4. Other Factors: The money supply is a function not only of the high powered money determined by the monetary authorities, but of interest rates, income and other factors. The latter factor change the proportion of money balances that the public holds as cash. Changes in business activity can change the behaviour of bank and the public and thus affect the money supply. Hence the money supply is not only an exogenous controllable item but also an endogenously determined item.


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