Money:
Under certain circumstances, barter exchange works. The complications associated with the requirements of a double coincidence of wants make the exchange of one good for another inefficient in the modern world. Money was invented to facilitate exchange. Money serves three functions. It is a medium of exchange, a measure of value, and a store of value. Some of the properties that money must have are that it must be durable, portable, divisible, homogeneous, and be relatively scarce. Gold has these characteristics and has long been used as money. Paper money called ‘fiat money’ works as well, as long as it is universally accepted as the medium of exchange. Money is usually described as a liquid asset because it exchanges easily for other assets.
Supply of Money:
The supply of money is a stock at their particular point of time, though it conveys the idea of a flow over time. The term the supply of money is synonymous with such terms as ‘money stock’, ‘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 the 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 a commercial bank. They are the liquid form of money because depositors can draw cheques for any amount lying in their accounts and the hank has to make immediate payment on demand. Demand deposits with commercial banks plus currency with the public are together denoted as money supply. This is regarded as a narrower, definition of the money supply.
The second definition is broader and is associated with the modern quantify theorists headed by Friedman. Professor 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 their credit at banks in the form of demand deposits, and also commercial bank time deposits. Time deposits are fixed deposits of customers in a commercial bank. Such deposits earn a fixed rate of interest varying with the time period for which the amount is deposited. Money can be withdrawn before the expiry of that period by paying a penal rate of interest to the bank.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 this definition includes M1 plus time deposits of commercial banks in the supply of money. This wider definition is characterized as in America and
in Britain and India. It stresses the store of value function of money or what Friedman called a temporary abode of purchasing power.
The third definition is the broadest and is associated with Gurley and Shaw. They include the supply of money, plus deposits of savings banks, building societies, loan 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 or blur the analysis of the various motives for holding cash and two from the point of view of monetary policy an appropriate definition should include the area over which the monetary authorities can have direct influence. If these two criteria are applied, none of the three definitions is wholly satisfactory.
Determinants of Money Supply
There are two theories of the determination 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 endogenously by changes in the economic activity which affects 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 the people to hold currency relative to deposits. The last two determinants together are called the monetary base or the high powered money.
1. The Required Reserve Ratio: The required reserve ratio or the minimum cash reserve ratio or the reserve deposit ratio is an important determinant of the money supply. An increase in the required reserve ratio reduces the supply of money with commercial banks and a decrease in the required reserve ratio increases the money supply. 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. But the short-term assets along with the cash are regarded as the liquid assets of a commercial bank. In India, the statutory liquidity ratio (SLR) has been fixed by law as an additional measure to determine the money supply.
2. The Level of Bank Reserves: The level of bank reserves is another determinant of the money supply. Commercial bank reserves consist of reserves on deposits with the central bank and currency in their tills or vaults. 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 a 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 deposits (D) of a commercial bank: RR= RRr x D. Thus the higher the reserve ratio, the higher the required reserves to be kept by a bank, and vice versa. But it is the excess reserves (ER) that are important for the determination of the money supply. Excess reserves are the difference between total reserves (TR) and required reserves (RR): ER=TR-RR. It is the excess reserves of a commercial bank that influence the size of its deposit liabilities. A commercial bank advances loans equal to its excess reserves which are an important component of the money supply. To determine the supply of money with a commercial bank, the central bank influences its reserves by adopting open market operations and discount rate policy.
3. Public's Desire to Hold Currency and Deposits: People's desire to hold currency (or cash) relative to deposits in commercial banks also determines the money supply. If people are in the habit of keeping less in cash and more in deposits with the commercial banks, the money supply 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. High Powered Money and the Money Multiplier: The current practice explains the determinants of the money supply in terms of the monetary base or high powered money. High-powered money is the sum of commercial bank reserves and currency (notes and coins) held by the public. High-powered money is the base for the expansion of bank deposits and the creation of the money supply. The supply of money varies directly with changes in the monetary base, and inversely with the currency and reserve ratios.
5. 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 factors change the proportion of money balances that the public holds as cash. Changes in business activity can change the behaviour of banks 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.
Measures/Structure/Components of Money Supply in India
There are four measures of money supply in India which are denoted by ,
,
, and
. This classification was introduced by the Reserve Bank of India (RBI) in April 1977. Prior to this till March 1968, the RBI published only one measure of the money supply, M or M1, defined as currency and demand deposits with the public. This was in keeping with the traditional and Keynesian views of the narrow measure of the money supply. From April 1968, the RBI also started publishing another measure of the money supply which it called Aggregate Monetary Resources (AMR). This included M1 plus time deposits of banks held by the public. This was a broad measure of money supply which was in line with Friedman's view. But since April 1977, the RBI has been publishing data on four measures of the money supply which are discussed as under.
: The first measure of money supply,
consists of:
(i) Currency with the public which includes notes and coins of all denominations in circulation excluding cash on hand with banks:
(ii) Demand deposits with commercial and cooperative banks, excluding inter-bank deposits; and
(iii) 'Other deposits' with RBI which include current deposits of foreign central banks, financial institutions and quasi-financial institutions such as IDBI, IFCI, etc, other than of banks, IMF, IBRD, etc. The RBI characterizes M1 as narrow money.
: The second measure of the money supply is
which consists of
plus post office savings bank deposits. Since savings bank deposits of commercial and cooperative banks are included in the money supply, it is essential to include post office savings bank deposits. The majority of people in rural and urban India have a preference for post office deposits from a safety viewpoint than bank deposits.
: The third measure of money supply in India is
which consists of
plus time deposits with commercial and cooperative banks, excluding inter-bank time deposits. The RBI calls
as broad money.
: The fourth measure of the money supply is
which consists of
plus total post office deposits comprising time deposits and demand deposits as well. This is the broadest measure of the money supply.
Of the four inter-related measures of money supply for which the RBI publishes data, it is which is of special significance. It is
that is taken into account in formulating macroeconomic objectives of the economy every year. Since
is narrow money and includes only demand deposits of banks. Along with currency held by the public, it overlooks the importance of time deposits in policymaking. That is why the RBI prefers
which includes total deposits of banks and currency with the public in credit budgeting for its credit policy. It is on the estimates of the increase in
that the effects of money supply on prices and growth of national income are estimated. In fact,
is an empirical measure of money supply in India, as is the practice in developed countries.
Additional Notes:
RR= RRr x D: If deposits amount of Rs 80 lakhs and required reserve ratio is 20 per cent, then the required reserves will be 20% x 80=Rs 16 lakhs. If the reserve ratio is reduced to 10 per cent, the required reserves will also be reduced to Rs 8 lakhs.
ER=TR-RR: If total reserves are Rs 80 lakhs and required reserves’ are Rs 16 lakhs, then the excess reserves are Rs 64 lakhs (Rs 80 - 16 lakhs). When required reserves are reduced to Rs 8 lakhs, the excess reserves increase to Rs 72 lakhs.
Open Market Operations (OMO): Open market operations refer to the purchase and sale of government securities and other types of assets like bills, securities, bonds, etc., both government and private in the open market. When the central bank buys or sells securities in the open market, the level of bank reserves expands or contracts. The purchase of securities by the central bank is paid for with cheques to the holders of securities who, in turn, deposit them in commercial banks thereby increasing the level of bank reserves. The opposite is the case when the central bank sells securities to the public and banks that make payments to the central bank through cash and cheques thereby reducing the level of bank reserves.
Discount Rate Policy: The discount rate policy affects the money supply by influencing the cost and supply of bank credit to commercial banks. The discount rate, known as the bank rate in India, is the interest rate at which commercial banks borrow from the central bank. A high discount rate means that commercial banks get fewer amounts by selling securities to the central bank. The commercial banks, in turn, raise their lending rates to the public thereby making advances dearer for them. Thus there will be the contraction of credit and the level of commercial bank reserves. The opposite is the case when the bank rate is lowered.
Reading List:
1. Jhingan, M.L. (2012), Micro Economic theory (12th edition). Vrinda Publications Pvt. Ltd, Delhi.
No comments:
Post a Comment