Module 2

Determinants of money supply

The change in total money supply is obtained by the product of high powered money and money multiplier
• A. High powered money or reserve money as RBI calls it, is the base of money supply
and thus, it is called as base money. High- powered money includes currency with
public (C), cash reserves of banks (R) and other deposits (OD) with the Reserve Bank. it
can be expressed as follows
• H=C+R+OD
• H is denoted as M0 by the RBI.
• B. Money Multiplier:- The total money supply in an economy is more than what was
initially supplied by the monetary Authorities.
• The value of money multiplier is determined by Currency Deposit Ratio and Reserve
Ratio.
• The preference by the public between currency and demand deposits is called currency
-deposit ratio (k). This ratio depends on the banking habits of people, level of income,
rate of interest, etc.
• The reserves of banks can be divided into two types: required reserves which are the statutory
reserves to be maintained by the commercial banks with the central bank & Excess reserves which
are voluntarily held by the banks- this is to meet their currency drain (which is the withdrawal of
cash by the depositors) and clearing drain (cash required to meet the cross clearing of cheques
among the banks) and these two together determine the Reserve - deposit ratio (r). This is the ‘r’
which finally determines the volume of credit that can be created by commercial banks.
• Thus money Multiplier is :-
• mm=(1+k)/(r+k)
• Illustration-
• If the currency deposit ratio is 0.40 and reserve ratio is 0.20 then the mm will be
(1+0.40)/(0.20+0.40)=2.33
• The change in total money supply is obtained by the product of high powered money and money
multiplier.
• So if High powered money is 10,000 billion then money supply will be 10,000*2.33= 23300.
C. Other factors
• The high powered money and money multiplier are influenced by some other factors also known as the
ultimate factors, these are as follows:-
• 1. Community's choice:- The community's choice regarding currency -deposit ratio is affected by banking habits,
availability of banking services, the price level, level of income, etc.

• 2. Velocity of circulation:- Money supply is influenced by velocity of circulation higher the velocity of circulation
higher is the money supply and vice versa the velocity of circulation as influenced by savings, price level,
payment habits etc.

• 3. Rate of interest:- Higher the interest rate less money will be held in cash and vice versa.
• 4. Monetary policy:- Monetary policy of the central bank plays an important role in credit creation and
therefore in money supply.

• 5. Fiscal policy:- Public authorities can also influence money supply through changes in public expenditure and
taxation policy. Deficit financing and public borrowing (reduces the money supply as it’s used for repaying
debts) also influences money supply.
 Velocity of circulation of money
• To know money supply over a period of time we should multiply the stock of money (M) by the velocity of circulation of
money (V). Velocity of money is further classified as-

• A. Transaction Velocity:-
• It is the ratio of annual volume of transaction to the stock of money.
• For example, suppose the total supply of currency and demand deposits in a given period is Rs.5000 crores and the
transactions conducted are of rupees 1,00,000 crores, then the transaction velocity is 20. Thus, a given unit of money, say,
rupees 1 performs the function of rupees 20 - this indicates the average speed of a unit of money.

• Factors determining transaction velocity

• 1. Volume of production and trade:- Higher the volume of production of goods (with money supply being constant),
greater will be the transaction and thus, more velocity.
• 2. Savings:- if people increase the savings, less money spent and thus, the velocity reduces and vice versa.
• 3. Changes in the price level:-during inflation or during the prosperity period in the business/trade cycle, money circulates
faster and during deflation the velocity declines.
• 4. Institutional arrangements:- if there are different payments, then the velocity will be lower and vice versa.
• 5. Regularity and certainty if income receipt:- if people are confident about regular income receipts, then money
circulation is faster and vice versa.
• B. Income velocity of money:-
• It refers to the average number of times a unit of money is used for making payments for final goods and
services. The concept is more popular with national income accounting techniques. It is the ratio of GNP to the
money stock, if the GNP is Rs 50,000 crores and Money stock (M1) is rupees 10,000 crores, the income velocity
of money is 5. the income velocity is always lower than the transaction velocity. Since, the former confines itself
to the final goods and services, while, the transaction velocity includes financial assets and sales of existing land
and building, these all things are excluded from income velocity.
• Factors determining income velocity
• 1. Growth of GNP:- increase in GNP (with money supply being constant) will require money to circulate
faster so as to purchase a large quantity of final goods and services and vice versa.
• 2. Demand for idle cash:- if the demand for idle cash increases, expenditure on final goods and
services declines, this reduces income velocity.
• 3. Quantity of money supply:- if the stock of money increases faster than the final goods and services, the
income velocity decreases, since there are less goods and services available to purchase.
 Causes of inflation
• A persistent & appreciable rise in prices over a period of time
generally one year is termed as inflation. Inflation can be due
to real factors like increase in aggregate demand without an
increase in aggregate supply and sometimes could be due to
monetary factors like increase in money supply. Inflation leads
to a decrease in the purchasing power of money.
A. Demand pull inflation
B. Cost push inflation
• Monetarists are of the view that inflation is always and
everywhere a monetary phenomenon. So inflation takes
place when there is a change in supply of money.
• According to modern approach to inflation when the
increase in price level is due to an increase in AD it is
called Demand Pull inflation and when it is due to
constraints on the AS side it is called cost push inflation.
• Economists are of the view that any inflationary process
is an interplay of demand pull and cost push factors,
whatever factor may be the cause of initial inflation.
 Types of inflation-causes
1. Demand pull inflation
 Explanation
• Consider fig. where AD and AS are measured along the x-axis and general
price level along the y-axis. Curve AS represents the aggregate supply which
rises upward in the beginning but when full employment level i.e. when AS
reaches OYF , it takes a vertical shape. This is because after the level of full
employment, supply of output cannot be increased. When aggregate
demand curve is AD1, the equilibrium point is at E1, less than full
employment level, where price level OP1 is determined. Now if the AD
increase to AD2, price level rises to OP2
• But since the AS curve is yet sloping upward, increase in AD from AD2 to AD3,
has increased the output from OY2 to Oyf
• if AD further increases to AD4 only price level rises to OP4 with the output
remaining constant at Yf . Oyf is the full employment level or output and AS
curve is perfectly inelastic at Yf
 Causes
• Increase in money supply: when the money supply is in excess of supply of goods
and services it results in additional demand leading to increase in price level.

• Deficit Financing An increase in money supply also takes place when the
government resorts to deficit financing to meet the public expenditure. Deficit
financing undertaken for unproductive expenditure becomes purely inflationary.
Even when it is used on productive activities, prices would still increase during the
gestation period. Modern governments incur huge expenditure on social security
measures. Besides deficit finance is incurred for promoting economic growth.
Heavy expenditure is also incurred during the war time resulting in increase in
money supply.

• Credit Creation Commercial banks contribute to increase in the quantity of money

in circulation when they give loans and advances through the process of credit
creation.
• Exports: Exports reduce the goods available in domestic market. Export earnings
enhance the purchasing power of the exporters and others linked with export An
increase in exports would aggravate the situation by reducing the supply of goods
and at the same time pushing up the demand.
• Repayment of public Debt: Public debt is a common feature of modern
governments. When such debts are repaid, people will have more income at their
disposal. Additional disposable income tends to raise the demand for goods and
services.
• Black money Social and economic evils like corruption, tax evasion, smuggling and
other illegal activities give rise to unaccounted or black money. People with black
money indulge in extravaganza expenditure, affecting demand and thus the price
level.
• Population : The size of the population is one of the important determinants of
demand. In many developing countries population is large in size and still
increasing . India provides an example where demand outstrips (exceeds)supply
due to the large and increasing population.
• Reduction in taxes, with no change in Government Expenditure.
• Decrease in imports
• Increase in government expenditure with no change in tax rates.
 II. Cost-push inflation
Inflation in terms of supply side is called cost push inflation. In the case
of such type of inflation, the costs are not absorbed by the firms, which
are producing goods but are passed on the consumer of goods.
Generally the cost push inflation takes place when there is an increase
in money wage rate which is in excess of the increase in labour
productivity. This leads to an increase in cost of production and thus, to
and upward shift in the supply curve. This will lead to an increase in
the price level.
As can be seen from the above diagram the AD curve and AS curve
intersect each other at point E. Determining the price level as OP. The
economy is at full employment line. If the cost of production rises due
to an increase in wage rate the new point of equilibrium is E1. The price
level goes up from OP to OP1 There is output reduction in the economy
by MM1. This kind of inflation is called cost push inflation. If there is
further rise in cost of production, the supply curve further shifts to S2
and the point of equilibrium E2 is attained. The price rises by P1 P2 and
the output further decreases by M1M2 amount.
 Causes
• Increase in wages : When prices increase-due to increase in wages it is called wage
push inflation. Trade unions play an important role in deciding the wage rate,
Strong and powerful trade unions succeed in securing higher wages for their
members. Higher wages granted in the organised sector influence the wage rate in
the unorganised sector too, resulting in an increase in cost everywhere. The
burden of higher wages is usually shifted forward to the consumers in the form of
higher prices.
• Higher material cost: Prices of materials used in producing goods constitute a
significant part of the cost. Prices of the materials may increase either due to an
increase in demand for these materials or independently owing to national and
international developments. When the prices of basic inputs like petroleum
products increase, the effect is felt throughout the economy. An increase in the
prices of materials especially the basic inputs alters the cost structure of all goods
and services Higher cost of production leads to upward revision of final prices,
Increase in material cost has become one of the important factors responsible for
continuous upward movement of price level.
• Large profit margin: Firms operating under oligopoly or enjoying
monopoly power may increase prices to have higher profit margin.
While firms enjoying some monopoly power will find easy to increase
prices, others will be compelled to raise their prices due to initial spurt
in prices. The desire to have higher profit margins by all those who
have the power to do so becomes the cause for inflationary trend.

• Devaluation: Devaluation increases price of imports and thus, leads to

inflation.

• Other factors : Cost of production may increase when input prices go

up due to scarcity - natural or artificial. Natural calamities like drought
or floods adversely affect the supplies of raw materials thus making
them dearer.
Effects
1. Inverse relation between inflation and unemployment rate.
2. Reduces real income or purchasing power. e.g. with Rs. 50 one could
purchase 2 units of a commodity and due to inflation Rs. 70 i.e. extra
Rs. 20 is required for purchasing same amount of the same
commodity.
3. Inflation that occurs after full employment leads to black marketing
and other illegal economic activities.
4. Income distribution- Entrepreneurs including Farmers earn good
profit, while fixed wage/salary earners suffer.
5. Creditors who lend money are losers as interest received turns out to
be less worth due to inflation, while it becomes easy for debtor to
repay loans. e.g. loan at 2% interest rate was lend by creditor and
inflation rate turns out to be 3%, thus creditors are at loss and
debtors can easily make repayment.
 Measures to control Inflation:-

1. Monetary measure:
The central bank can increase bank rate, cash reserve ratio and statutory liquidity ratio so as
that overall money supply comes down and with that the inflation comes down. The central
bank also make use of qualitative methods to reduce credit creation for particular purposes
and sectors in economy.
2. Fiscal measures:
Increase in taxation will reduce disposable income in hands of public, which reduces
consumption expenditure and thereby will reduce demand; and thus with reduction in
demand, prices of goods and services will come down, therefore inflation will be controlled.

3. Direct Measures:
When inflation is very high govt can import those commodities or can sell it at lower price
through Public Distribution System which operates in the country through the channels of
ration shops, thus inflation can be controlled for essential commodities in the country.
Monetary policy: Objectives and instruments
• What is Monetary Policy?
• Monetary policy is an economic policy that manages the size
and growth rate of the money supply in an economy. It is a
powerful tool to regulate macroeconomic variables such
as inflation and unemployment.
• These policies are implemented through different tools,
including the adjustment of the interest rates, purchase or
sale of government securities, and changing the amount of
cash circulating in the economy. The central bank or a similar
regulatory organization is responsible for formulating these
policies.
Objectives of Monetary Policy
• The primary objectives of monetary policies are the management of inflation or unemployment, and
maintenance of currency exchange rates.
• 1. Inflation
• Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the
economy. If inflation is high, a contractionary policy can address this issue.
• 2. Unemployment
• Monetary policies can influence the level of unemployment in the economy. For example, an expansionary
monetary policy generally decreases unemployment because the higher money supply stimulates business
activities that lead to the expansion of the job market.
• 3. Currency exchange rates
• With the help of fiscal authority, a central bank can regulate the exchange rates between domestic and foreign
currencies. For example, the central bank may increase the money supply by issuing more currency. In such a
case, the domestic currency becomes cheaper relative to its foreign counterparts.
• 4. Balance of Payment (BoP) Equilibrium: if monetary equilibrium is maintained that is there is no surplus or
deficit then BoP equilibrium will be maintained

• 5. Economic Growth: A suitable Monetary Policy would help with the proper utilization of natural and human
resources, more capital formation, more employment, increase in national and per capita income along with
an increase in the standard of living.
 Quantitative Tools/instruments of Monetary
•
Policy
Central banks use various tools to implement monetary policies. The widely utilized policy tools include:
• 1. Interest rate adjustment
• A central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to
banks for short-term loans. For example, if a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the
banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will
decrease.
• 2. Change reserve requirements Central banks usually set up the minimum amount of reserves that must be held by a commercial bank in form of
CRR and SLR. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the
required reserve amount, commercial banks find less money available to lend to their clients and thus, money supply decreases.
• Commercial banks can’t use the reserves to make loans or fund investments into new businesses. Since it constitutes a lost opportunity for the
commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required
reserves).
• 3. Open market operations The central bank can either purchase or sell securities issued by the government to affect the money supply. For example,
central banks can purchase government bonds. As a result, banks will obtain more money to increase the lending and money supply in the economy.
4. Depending on its objectives, monetary policies can be expansionary or contractionary.
• Expansionary Monetary Policy
This is a monetary policy that aims to increase the money supply in the economy by decreasing interest rates, purchasing government securities by central
banks, and lowering the reserve requirements for banks. An expansionary policy lowers unemployment and stimulates business activities and consumer
spending. The overall goal of the expansionary monetary policy is to fuel economic growth. However, it can also possibly lead to higher inflation.
• Contractionary Monetary Policy The goal of a contractionary monetary policy is to decrease the money supply in the economy. It can be achieved by
raising interest rates, selling government bonds, and increasing the reserve requirements for banks. The contractionary policy is utilized when the
government wants to control inflation levels.
Qualitative tools of the Monetary policy
are given in the following:
1. Margin Requirements: the banks gives us loan against the Mortgage of any kind of
property and asset of us , if margin is greater than lesser will be the loan sanctioned and
vice versa.
2. Consumer credit control : under this RBI give the direction to the commercial banks that
they have to increase repayment amount with less no. of installments from the customer -
discouraging the demand for money or decrease the repayment amount with greater no. of
installments from the customer - encouraging the demand for money.
3. Direct action : RBI takes the direct action on the customers for flow of the money in the
economy.
4. Moral suasion: under this RBI verbally request the commercial banks for decrease or
increase the interest rates
• 5 Rationing of Credit
RBI fixes a credit amount to be granted for commercial banks. Credit is given by limiting the
amount available for each commercial bank. For certain purposes, the upper credit limit can be
fixed, and banks have to stick to that limit. This helps in lowering the bank's credit exposure to
unwanted sectors. This instrument also controls the bill rediscounting.
• 6 Directives: The central bank can issue written or oral directives to banks to follow certain lines of
action.
Inflation Targeting
• Inflation targeting is basically a monetary policy system wherein the central bank of a country (RBI in India) has a specific target inflation
rate for the medium-term and publicises this rate.As per the new framework, the central government, in consultation with RBI sets: (i) an
inflation target, and (ii) an upper and lower tolerance level for retail inflation. The target has been set at 4%, with an upper tolerance limit of
6% and a lower tolerance limit of 2%.
• How is Inflation Targeting done?
• A central bank seeks to readjust its monetary policy by doing inflation targeting. This is done by raising or lowering interest rates based on above-target or
below-target inflation, respectively. The conventional wisdom is that raising interest rates usually cools the economy to control inflation; lowering interest rates
usually accelerates the economy, thereby boosting inflation. The first three countries to implement fully-fledged inflation targeting were New Zealand, Canada and
the United Kingdom in the early 1990s, although Germany had adopted many elements of inflation targeting earlier.
• What are the benefits and drawbacks of Inflation Targeting?
• Like all monetary policy instruments, inflation targeting comes with its fair share of benefits and drawbacks, they are the following:
• Benefits
• Inflation targeting allows monetary policy to “focus on domestic considerations and to respond to shocks to the domestic economy”, which is not possible under a
fixed-exchange-rate system.
• Transparency is another key benefit of inflation targeting. Central banks in developed countries that have successfully implemented inflation targeting tend to
“maintain regular channels of communication with the public”.
• An explicit numerical inflation target increases a central bank’s accountability, and thus it is less likely that the central bank falls prey to the time-inconsistency trap.
This accountability is especially significant because even countries with weak institutions can build public support for an independent central bank.
• Inflation Targeting Drawbacks
• There is a propensity of inflation targeting to neglect output shocks by focusing solely on the price level.
• Leading economists argue that inflation targeting would be restoring the balance missing from a monetary policy based solely on the goal of price stability, thus
neglecting other factors of an economy as well.
Nature of inflation in developing economy
• Both types of inflation plays role, while
only one exerts more than other at Cost push factors
times. Rather it is the by product of the 1. Inelastic supply
development process. 2. Backward agricultural sector
3. Supply shocks
• Demand pull inflation: 4. Change in exchange rate
1. Increase in income 5. Increase in wages
6. Infrastructure bottleneck
2. Huge expenditure 7. Inefficient public sector
3. Gestation period 8. Inefficient and dishonest administration
4. Increasing population
5. Unproductive expenditure
6. Foreign aid capital
Keynes’ Theory of Demand for Money
•Keynes’ approach to the demand for money is based
•on two important functions-
•1. Medium of exchange
•2. Store of value
•Keynes explained the theory of demand for money
•with following questions-
•1. Why do people prefer liquidity?
•2. What are the determinants of liquidity preference?
Motives for Liquidity Preference

•The Transactions Demand for Money-People require money to carry out day-to-day
transactions but most of them receive income once in a month- Individuals hold cash in order
“to bridge the interval between the receipt of income and its expenditure”.

•Precautionary Demand for Money-It is necessary to be cautious about future which is

uncertain. Precautionary motive for holding money refers to the desire of the people to hold
cash balances for unforeseen contingencies.

•Keynes holds that the transaction and precautionary motives are relatively interest inelastic,
but are highly income elastic.

•The amount of money held under these two motives (M1) is a function (L1) of the level of
income (Y) and is expressed as M1 = L1 (Y)
Cont…
•Speculative Demand for Money- The cash held under this motive is used, to make
speculative gains by dealing in bonds whose prices fluctuate.
•According to Keynes, the higher the rate of interest, the lower the speculative demand for
money, and lower the rate of interest, the higher the speculative demand for money.
Algebraically, the speculative demand for money is:

•M2 = L2 (r)

•Where, L2 is the speculative demand for money, and r is the rate of interest.
Liquidity Preference Curve/liquidity trap (Cont…)

The curve becoming straight horizontal

from left to right indicates that interest
rate will not fall below this level and bulls
also turn out to be bear during this phase.