Supply of Money

Introduction

Money supply means the total amount of money in an economy. The effective money supply
consists mostly of currency and demand deposits.

Currency includes all coins and paper money issued by the government and the banks. Bank
deposits (payable on demand) are regarded part of money supply and they constitute about 75 to
80 per cent of the total money supply in the US. Some economists also include near money, or
such liquid assets as savings, deposits and government bills in the money supply. The total
supply of money is determined by banks, the Federal Reserve, businessmen, the government and
consumers.

For theoretical purposes money is defined as any asset which performs the functions of money—
but in actual practice, there are many financial assets which perform these functions to a greater
or lesser degree and this makes it difficult to measure empirically the magnitude of money. It
should be noted that ‘money supply’ which refers to the total stock of domestic means of
payment owned by the ‘public’ in a country, we consider the stock of money in spendable form
only to be the main source of money supply.

In other words, the cash balances held by the central and state governments with the Central
Bank and in treasuries are generally excluded on the ground that they arise out of the non-
commercial, particularly administrative operations of the government. Thus, the ‘quantity of
money’ means the ‘total amount of money in circulation’ in existence at a time.

Money is something which is measurable. Supply of money refers to its stock at any point of
time, it is because money is a stock variable as against a flow variable (real income). It is the
change in the stock of money during a period (say a year), which is a flow. The stock of money
always refers to the stock of money held by the public. Throughout history the question of not
only what constitutes money but where it comes from has been both important and controversial.
In contrast to income, which is measured over time; the money is a stock, not a flow. Since
money is a stock, it means that the amount of money in existence at any point of time must be
held by some entity in the economy. Economists make a distinction between amount of money in
existence at any point of time and the amount that people and institutions may want to hold for
various reasons. When the amount of money actually being held coincides with the amount of
money individuals, business houses and governments actually want to hold; a condition of
monetary equilibrium exists.

A distinction must be made between the current deposits or current accounts of banks which
have the status of money and deposit accounts (fixed or savings deposits) which do not have the
status of money and are at best regarded quasi-money or near money. The reason being that time
deposits of commercial banks can be drawn only at the end of a fixed period or earlier by paying
a penalty or by obtaining prior permission. These are no doubt a store of value but are not the
means of payment but only equivalent to means of payment.

These are no doubt liquid assets but they are not so liquid enough as to rank as money. What
distinguishes these deposits is the fact that they earn an interest income and can be converted as
means of payment only after some delay and not at once. As such, these time and saving deposits
are excluded from the pool of the money supply.

However, alternative definitions of money have been adopted by many writers. Notably, the
Chicago School led by Milton Friedman opts to include all bank deposits, time and demand, in
money supply. In fact, Schwartz and Friedman are willing to consider as money all marketable
government securities which are supported at par. By the same logic, there is no reason why the
liabilities of saving institutions should not also be included in money.

The debatable question is whether the measure of money should be extended to include other
deposits liabilities of the commercial banks, e.g., time deposits in USA and deposit accounts in
the UK. Some investigators go further and include the liabilities of some other deposit taking
institutions, such as savings and loan associations in the USA and saving banks in Britain, on the
grounds that their fixed monetary value—and usually the ease of encashment—makes them good
substitutes for interest bearing bank deposits.
It has, therefore, to be observed that various measures of money supply keep on changing from
country to country and from time to time within the country. As such, the measurement of money
supply becomes an empirical matter. Up to 1968, the RBI published a single measure of money
supply (called M and later on M1) defined as currency and demand deposits (dd), held by the
public. It was called the narrow measure of money supply. After 1968 the RBI started publishing
a ‘broader’ measure of money supply called aggregate monetary resources (AMR) defined as M
or M1 plus the net time deposits of banks held by the public (M3).
However, since 1977 RBI is publishing data on four alternative measures of money supply
denoted by M1, M2, M3and M4 as follows:
M or M1 = c + dd + od
M2 = M1 + Savings deposits with post office saving banks
(AMR) M3 = M1 + net time deposits of banks
ADVERTISEMENTS:

M4 = M3 + total deposits with post office saving banks.

where c stands for currency held by public; dd, net demand deposits of banks; od implies other
deposits of the RBI. Currency includes paper currency and coins, that is notes issued by the RBI
and one rupee and other small coins issued by the Government of India.

Net demand deposits include deposits held by public and not inter-bank deposits—deposits held
by one bank for another. These are not held by public hence excluded. Other deposits (od) of the
RBI are its deposits other than those held by the government (Central and State Governments),
banks, and a few others. These other deposits constitute very small proportion (less than one per
cent) of the total money supply, hence could be ignored.

Each definition of money supply from M1 to M4 has its adherents; but by and large most
economists prefer the most common sense and most acceptable definition of money or money
supply, that is, M1—because it includes everything that is generally acceptable as a means of
payment but no more. Once you go beyond currency and demand deposits, it is hard to find a
logical place to stop, since many things (bonds, stocks, debt instruments) contain liquidity in
varying degree. It is better, therefore, to stick to M 1 definition of money supply including
currency plus all demand deposits.
High powered money and measurement of money supply:
It should be noted that money supply is not always policy determined. In fact, money supply is
determined jointly by monetary authority, banks and the public. It is true that the role of
monetary authority is predominant in determining the supply of money.

Two types of money must be distinguished:

(i) Ordinary money (M) and

(ii) High powered money (H).

Ordinary money (M) as we have known is currency plus demand deposits: M = C + dd. On the
other hand, high powered money (H) is the money produced by the RBI and the government of
India (small coins including one rupee notes) held by the public and banks.

The RBI calls it H ‘reserve money’. H is the sum of:

(i) Currency held by public (c);

(ii) Cash reserves of the banks (R); and

(iii) Other deposits of RBI (od), we can ignore item (iii) from theoretical discussion as it hardly
constitutes one per cent of total H. Hence, H = C + R. Now, if we compare the two equations of
two types of money ordinary money (M – C + dd) and high powered money (H = C + R), we
find C is common to both; the difference between the two M and H is due to dd in M and R in H.
This difference is of vital importance. Banks are producers of demand deposits (dd) and these
demand deposits are treated as money at par with currency (c).

But to be able to create (or produce) dd; banks have to maintain R, which in turn, is a part of H,
produced only by monetary authority and not by banks. We know in a fractional reserve banking
system, dd are a certain multiple of R, which are a component of H; it gives H the quality of high
powered-ness (high powered money as compared to M)—the power of serving as the base for
multiple creation of dd. That is why, H is also called “base money’. H thus becomes the single
most dominant factor of determining money supply—called H theory of money supply’—also
called money-multiplier theory of money supply.
The actual measurement of money in the modern economy has become an extremely complex
matter because a fairly large variety of financial assets exist in the economy that serves as money
in one way or another. Before the growth of a large variety of ‘near monies’, the circulating
media (ordinary money M) could be described adequately by the term ‘deposit money’ or
‘deposits’, since a good part of the ordinary money (M) that actually circulated in the economy
consisted of demand deposits in ‘nations’ commercial banks. But it is too restricted now on
account of the growth of new varieties of near monies.

Monetary base which is also called central bank money—consists of all reserves of financial
institutions on deposit with the central banks and all currency in actual circulation or in the vaults
of commercial banks. This central bank or base money which is also called ‘high powered
money’ is the primary means through which the central bank can influence the total money
supply in the economy.

It is also called high powered because every unit (rupee) of central bank money provides a
support base for several units (rupees) of money in actual circle. The monetary base is important
because changes in it have the power to produce multiple change circulating money. The size of
the monetary base in turn changes or fluctuates with changes in asset and liabilities of the central
bank.

Thus, what the central bank has under its control is the size of money base (central bank money)
—Whether or not changes in the monetary base actually lead changes in money in circulation
depends upon how the public (including banks and other finance institutions) react to such a
change. It is for public to decide whether or not to change its holdings currency, deposits and
financial assets that serve as money in response to change in monetary base. Hence, the link
between monetary base and the total money in circulation is a real one; though it is not an exact
and mechanical one.

Thus, let it be clear that:

(i) The total supply of money or stock is determined by the behavior of banks in their decision
concerning the size of reserve ratio they wish to maintain,
(ii) By the behavior of the non-bank public in their decision to divide their money balances
between currency and demand deposits at commercial banks; and

(iii) By monetary authorities in their decision to change the size of the monetary base and the
exercise of their legal authority to set the minimum amount of reserves banks must hold.

It is, therefore, clear that interactions among the actions of the public, the banks and the
monetary authorities (central banks) determine the money supply. Behavior of the public
depending on currency deposit ratio C/D, that of banks on reserve deposit ratio R/D and that of
monetary authorities by the stock of high powered money or the monetary base H. However,
keeping in line with the recent developments in monetary theory, it will be fruitful to adopt the
narrow concept of money—currency plus demand deposits—based on the means of payment
criterion which facilitates the formulations of a theory of asset choices.

Further, it may also be noted what we exclude from the money supply of a country—the
monetary gold stock which serves as international money and is not permitted to circulate within
the country; as also we must exclude the currency and demand deposits owned by the treasury,
the central bank, and the commercial banks, which are money issuing institutions holding these
funds partly as reserves to support publically owned demand deposits.

These exclusions are in order because their inclusion i.e., of both the cash holdings of money
issuers and the monetary super-structure supported by these holdings would involve double
counting. Thus, for all practical purposes, the money supply with public consists of currency
(notes and coins) and demand deposits with banks.

In the income and employment analysis quite often money supply is taken and as exogenous
variable (depending on the administrative action of the central bank). This convenient
simplification has been followed in the employment theory from time to time. But in actual
practice the empirical studies on money supply data have shown that it is not at all necessary to
assume that the money supply is exogenous—that is, unrelated functionally to other variables in
the economic system.
The trend in recent analysis (especially after Friedman) is to treat money supply endogenously,
as a variable functionally related to other variables in the economic system. A useful approach
along those lines has been developed by Ronald Teigen (of University of Michigan). He suggests
a money supply function that reflects both—the profit maximizing decisions of the commercial
banks and the policy actions of the Central Bank.

It is, therefore, clear that changes in H are policy controlled—while changes in M are largely
endogenous, that is, are such as depend mainly on the behavioral choices of the public and
banks. That is why it is said that monetary authority will do well to consider M as something
outside its control and concentrate its efforts to control H in order to control M. Efforts to control
M directly except through H route (or base money) are bound to prove self-defeating.

Supply of Money—Its Main Components:

It is by now clear that the main components of the supply of money are coins (standard
money): paper currency and demand deposits or credit money created by commercial
banks:
The term ‘Monetary Standard’ refers to the type of standard money used in a monetary system.
As a matter of fact, the monetary system of a country is generally described in terms of its
standard money. The monetary standard, therefore, is synonymous with the standard money.
(Monetary system consists of its standard money plus all the paper and credit substitutes tied to
and convertible into standard money). When the standard monetary unit is gold, a country is said
to have a gold standard system; if the standard monetary unit is defined in terms of both gold and
silver, the system is one of bimetallism.

If, however, a country’s currency is not convertible in either gold or silver, it is said to be an
inconvertible paper money standard. Thus, it is customary to describe the monetary system of a
country in terms of its standard money which constitutes the chief source of its supply. It may be
noted that the adoption of a particular monetary standard in a country at a particular time,
depends upon the economic conditions prevailing there. However, monetary standard which,
thus, becomes an essential part of the monetary system, has to be such as will facilitate elastic
money supply, economic development and promote the welfare of the people.
A suitable monetary system is one which satisfies both domestic requirements and the necessities
of international trade. Generally speaking, the monetary system and, therefore, the monetary
standards are guided by internal needs of a particular country, though the international aspects of
currency management cannot be ignored.

Countries are no more closed economies. A good money supply system is based on good
monetary standard; it must be certain inasmuch as its rules should be clear to the public; simple
in working and should be able to create confidence in the public mind besides being economical.
Moreover, a good monetary standard or money supply system, should ensure automatic working
and control over excessive issue of money supply.

Further, it has to be elastic so that currency can expand and contract according to the
requirements of the economy and, above all, it should be able to secure stability of prices as well
as rates of exchange. It is, however, difficult to find a unique monetary standard or money supply
system which entirely satisfies both domestic and international requirements of money supply. It
has, therefore, assumed different forms from time to time. The standard money or a system of
money supply, when it consisted of gold coins took the form of either gold coin standard or gold
bullion standard or gold exchange standard.

A comparative study:

A comparative study of the features of the three variants of the gold standard would convince
anyone about the efficacy of the post war gold standard variants (gold-exchange standard and
gold-bullion standard) and the system of money supply based on it. Gold-exchange standard is
said to have, more or less, the same uses as the gold-coin standard, at the same time economizing
the use of gold and freeing the authorities from the botheration of coinage.
This made it possible for the poor countries to reap the benefits of gold-coin standard and was
more in accordance with the monetary environment prevailing in the post-World War, though
such a system of money supply called for greater monetary management. It is rather difficult for
anyone variant of the gold standard to claim undisputed supremacy regarding the regulation of
money supply and its control. Having dismissed bimetallism as the standard which does not
merit serious consideration, gold-coin standard was strongly favored.
Though a causality of the two World Wars and the Great Depression, it still commands respect
and even liking in certain circles, leaving the choice in favor of a particular variant under the
circumstances prevailing in a country. However, modern system of money supply is primarily
based on managed currency system.

Paper Currency:
The paper currency also described as the managed currency standard or the fiat standard, refers
to a monetary system in which the standard currency of the country in circulation consists mainly
of paper money. Paper standard or the fiat standard as distinguished from metallic standards is
essentially the by-product of the World War I, for, before that, world currencies consisted mainly
of full-bodied coins made of silver or gold or both.

The period following the World War I ushered in an era of inconvertible paper money. The paper
standard or the fiat standard or the managed standard is distinct from other monetary standards
inasmuch as, under it, there is no convertibility of the paper currency in any metal. As a result,
the volume of paper currency is determined by the considerations of convenience and economic
activities rather than by the volume of metal. Moreover, paper currency system is nationalistic as
there is no common link between the different currency systems.

Thus, the important features of paper currency standard are:

1. Paper money is the standard money and is accepted as unlimited legal tender in the discharge
of obligations;

2. Paper money is not convertible into gold or any other metal;

3. The volume of paper currency is controlled by the monetary authority (central bank), which
expands or contracts the currency according to the requirements of the economy;

4. Though the standard money is made of paper, there may be in circulation metallic coins also
being unlimited legal tender;

5. For purposes of foreign trade the rate of exchange is determined on the basis or parity between
the purchasing power of the currencies of the respective countries.
Suppose one dollar in the United States has the same purchasing power is hundred francs in
France, then one dollar will be equal to 100 francs. Since the intrinsic value (real value) of paper
money is less than its value as money (face value) and further as it is not convertible into some
other form of metal money, it is also referred to as fiat money and the standard as fiat standard.
Moreover, the quantity of money in circulation is regulated and managed by the appropriate
monetary authority in the country with a view to bringing stability in prices and incomes;
therefore, it is also called managed currency system.

The backbone of the currency system is the central bank notes and coins because central bank
has the monopoly of note issue, though in certain countries the treasury also issues notes or coins
along with the central bank. In India, for instance, one rupee notes are issued and managed in
circulation by the government of India, Ministry of Finance, and the rest of the notes and coins
are issued and managed by the Reserve Bank of India. Supply of paper money in the country is
governed by the system laid down for the purpose.

Broadly speaking, there are three important methods of note issue:

(i) The fixed fiduciary system,

(ii) The proportional reserve system, and

(iii) Minimum reserve system.

The first one is in vogue in UK and the second one is prevalent in USA and the third one in India
at present. In India proportional reserve system also prevailed up to mid-1950s. Then the
minimum reserve system replaced it. How much currency of particular denomination will be in
circulation and its proportion to the total money supply are governed by the actions of the public.

The treasury, the commercial banks and the central bank are the agencies through which the
preference of the public is expressed. According to the Board of Governors of the Federal
Reserve System, “Neither the central bank nor the treasury has under ordinary circumstances any
direct way of keeping in circulation a larger amount of currency than the public requires or of
reducing the amount of currency that the public needs to finance its current operations”.
The desire of the public to hold more or less currency or more or less of particular denominations
is normally influenced by many factors like the volume of trade, nature of trade—whether
wholesale or retail price level, methods of payments, banking habits of public, volume of
demand deposits, volume of transactions, distribution of national income, methods of taxation,
public loans, deficit financing, etc.

Demand Deposits:
In most of the economically advanced countries like UK and USA the bulk of the total supply of
money is deposit money which refers to the commercial banks’ total demand deposit. As such the
course of behaviour of the internal price level is greatly affected by changes in the volume of
deposit money or bank credit. These demand deposits of the commercial banks are the outcome
of the public deposits with the banks, and bank loans, advances and investments.

The public deposits which are cash deposits are called ‘primary deposits’ because they are the
result of the real savings of the people and deposits which are the result of banks’ loans and
advances to customers are called ‘derivative deposits’ and represent the creation of credit by
banks. The relative amounts of the two main sources of money supply, viz., the currency and
demand deposits, depend upon the degree of monetization of the economy, banking habit,
banking development, trade practices, etc. in the economy.

For example, almost 80 per cent of the money supply of the US is made of demand deposits.
While in underdeveloped countries like India, the proportion of the currency money to the total
money supply with the public is considerably large because a very high percentage of
transactions are performed through cash payments rather than credit instruments like cheques,
etc.

Changes—Elasticity and Velocity of Money:

Although these terms are being used interchangeably in monetary economics, yet it would be
useful to understand the distinction amongst these terms and to use them as such. Changes imply
simple variations in the total quantum of money supply due to the changes in the expenditures of
the government exceeding its revenue (through taxes and borrowings)—the supply of money in
the economy may increase. This happens because the excess expenditure of the government
sector is to be financed either by taking loans from the central bank or by selling government
securities to the banking system or by way of printing more money (deficit financing), and this,
in turn, changes the supply of money.

Similarly, the private sector (domestic and foreign) also affects the money supply by increasing
or decreasing loans and advances from the banking system as also by making purchases and
sales of shares and securities from and to the banking sector. These are all instances of a simple
and ordinary change or variation in money supply.

The ability of the supply of the circulating media to adjust itself to changes in the volume of
trade without affecting the general price level is often termed as ‘monetary elasticity’. In other
words, ‘elasticity of money’ to adjust itself in an appropriate manner to implied changes in the
needs for money is the ability in order to meet or mitigate the seasonal or cyclical monetary
demand. Elastic money supply refers to the situation occurring in a monetary system in which
the volume of currency in circulation can be varied to meet different needs.

The degree of monetary elasticity depends on the action and power of the central bank. If the
money market is well organized and developed the central bank can perform the function of
monetary elasticity with efficiency. Thus, a change in needs necessitates a change or variation in
money supply and this, in turn, necessitates elasticity in the supply of money.

So far our analysis remained confined to the total supply of money at a moment of time. We are
equally interested in finding out what the supply of money is over a period of time, say a year,
and for this we have to bring into the picture what is called the velocity of circulation of money.
It is the basic function of money that has to be re-spent.

The average number of times each unit of money changes hands or is spent on goods and
services during a given period is called velocity of money. Therefore, the supply of money
during a given period is the total amount of money in circulation (M) multiplied by the average
number of times it changes hands during that period (V). In algebraic terms the supply of money
during a given period is denoted by MV. Velocity will depend upon the time involved in
receiving and spending the money, methods and habits of payments, trade and business
conditions, liquidity preference, etc. A concept closely related to the transactions velocity of
money is the income velocity of money, which is the number of times that money moves from
one income recipient to another. It can be derived by dividing the total national product by the
money supply.

The issue whether there is any ceiling to an increase in the income velocity of money is an
unsettled one. Views on this matter differ sharply. The Radcliffe Report does not find “any
reason for supposing or any experience in monetary history indicating, that there is any limit to
the velocity of circulation.” In sharp contrast to this view, Newlyn contends that, “…a
specialised exchange economy necessarily involves the holding of the medium of exchange over
time. However, efficient the monetary system, there must, therefore, be some finite limit to the
velocity of circulation and the more the rate of interest is prevented from rising by rationing, the
lower this limit will be.”

Similarly, Ritter has argued that “as interest rates continue to rise, due to continued monetary
restraint and persistent demand for funds, idle balances are likely to approach minimum
levels. Correspondingly, velocity is likely to encounter an upper limit, a rough and perhaps
flexible ceiling, but a ceiling nevertheless.” In brief, we can say that given the quantity of
money there is likely to be a limit to the rise in money income or, in other words, there is ceiling
to the rise in income velocity of money.