Definition of 'Money Supply'

Definition: The total stock of money circulating in an economy is the money supply. The
circulating money involves the currency, printed notes, money in the deposit accounts and in the
form of other liquid assets.
Money supply refers to the amount of domestic currency that circulates in a national economy
during a specified period. Money supply includes cash, coins, and money held in savings and
checking accounts for short-term payments and investments.

Main determinants of the supply of money are (a) monetary base and (b) the money
multiplier:
Main determinants of the supply of money are (a) monetary base and (b) the money multiplier.
These two broad determinants of money supply are, in turn, influenced by a number of other
factors. Various factors influencing the money supply are discussed below:

1. Monetary Base:
Magnitude of the monetary base (B) is the significant determinant of the size of money supply.
Money supply varies directly in relation to the changes in the monetary base.

Monetary base refers to the supply of funds available for use either as cash or reserves of the
central bank. Monetary base changes due to the policy of the government and is also influenced
by the value of money.

2. Money Multiplier:
Money multiplier (m) has positive influence upon the money supply. An increase in the size of m
will increase the money supply and vice versa.

3. Reserve Ratio:
Reserve ratio (r) is also an important determinant of money supply. The smaller cash-reserve
ratio enables greater expansion in the credit by the banks and thus increases the money supply
and vice versa.

Reserve ratio is often broken down into its two component parts; (a) excess reserve ratio which is
the ratio of excess reserves to the total deposits of the bank (re = ER/D); (b) required reserve ratio
which is the ratio of required reserves to the total deposits of the bank (r r = RR/D). Thus r = re +
rr. The rr ratio is legally fixed by the central bank and the re ratio depends on the market rate of
interest.
4. Currency Ratio:
Currency ratio (c) is a behavioral ratio representing the ratio of currency demand to the demand
deposits. The effect of the currency ratio on the money multiplier (m) cannot be clearly
recognized because enters both as a numerator and a denominator in the money multiplier
expression (1 + c/r(1 +t) + c). But, as long as the r ratio is less than unity, a rise in the c ratio
must reduce the multiplier.

5. Confidence in Bank Money:

General economic conditions affect the confidence of the public in bank money and, thereby,
influence the currency ratio (c) and the reserve ratio (r). During recession, confidence in bank
money is low and, as a result, c and r ratios rise. Conversely, during prosperity, c and r ratios
tend to be low when confidence in banks is high.

6. Time-Deposit Ratio:
Time-deposit ratio (t), which represents the ratio of time deposits to the demand deposits is a
behavioral parameter having negative effect on the money multiplier (m) and thus on the money
supply. A rise in t reduces m and thereby the supply of money decreases.

7. Value of Money:
The value of money (1/P) in terms of other goods and services has positive influence on the
monetary base (B) and hence on the money stock.

8. Real Income:
Real income (Y) has a positive influence on the money multiplier and hence on the money
supply. A r se in real income will tend to increase the money multiplier and thus the money
supply and vice versa.

9. Interest Rate:
Interest rate has a positive effect on the money multiplier and hence on the money supply. A rise
in the interest rate will reduce the reserve ratio (r), which raises the money multiplier (m) and
hence increases the money supply and vice versa.

10. Monetary Policy:

Monetary policy has positive or negative influence on the money multiplier and hence on the
money supply, depending upon whether reserve requirements are lowered or raised. If reserve
requirements are raised, the value of reserve ratio (r) will rise reducing the money multiplier and
thus the money supply and vice versa.

11. Seasonal Factors:

Seasonal factors have negative effect on the money multiplier, and hence on the money stock.
During holiday periods, the currency ratio (c) will tend to rise, thus, reducing the money
multiplier and, thereby, the money supply.
What are the Two Main Views of Money Supply?
Monetary economists hold different views regarding the constituents of money supply. Broadly,
there are two views: the traditional view and the modern view.

1. Traditional View:
According to the traditional view, money supply is composed of (a) currency money and legal
tender, i. e., coins and currency notes, and (b) bank money, i.e., chequable demand deposits with
the commercial banks

2. Modern View:
According to the modem view, the phenomenon of money supply refers to the whole spectrum of
liquidity in the asset portfolio of the individual.

Thus, in the modem approach, money supply is wider concept which includes (a) coins, (b)
currency notes, (c) demand deposits with the banks, (d) time deposits with the banks, (e)
financial assets, such as deposits with the non-banking financial intermediaries, like the post-
office saving banks, building societies, etc., (f) treasury and exchange bills, (g) bonds and
equities.

The basic difference between the traditional and modern views is due to their emphasis on the
medium of exchange function of. Money and the stock of value function of money respectively.

While the acceptance of medium of exchange function of money supply gives a narrow view of
money supply, the recognition of the store of value function of money provides a broader
concept of money supply and allows for the substitutability between money (which is
traditionally defined as a medium of exchange) and the whole spectrum of financial assets.

Difference between stock of money and money supply:

In ordinary language, money supply means the amount of total legal tender money in a country
at a point of time. Actually speaking money supply is nothing but stock of money.

Second meaning of supply related to money is not in the sense in which supply of a commodity
is interpreted Supply of a commodity relates to the prevailing market price but there is no
determinant like that for supply of money.

In reality, supply of money is the stock of money which is used for buying goods and services at
a point of time.

Therefore, money supply means the total quantity of money which includes notes and coins in
circulation and bank money.
Brief notes on four broad approaches of money supply
Economists are not in agreement on the question of definition of money supply. There are four
broad approaches of money supply. They are as follows:

1. Traditional Approach:
The traditional approach emphasizes the medium of exchange function of money. According to
this approach, money supply is defined as currency with public and demand deposits with
commercial banks. Demand deposits are the current accounts of depositors in a commercial
bank.

The traditional approach is analytically superior because it provides the most liquid and exact
measure of money supply.

In symbol, M = Cp + Dd

The central bank can have better control over the money supply if it includes currency and
demand deposits of banks alone. But, this approach limits money supply to a very narrow area.

2. Monetarist Approach:
The Chicago School led by Milton Friedman includes in money supply currency plus demand
deposits plus time deposits. Time deposits are fixed deposits of the banks which earn a fixed rate
of interest depending upon the period for which the amount is deposited.

In symbol, M = Cp + Dd + Td

According to Friedman money is defined as “anything that serves the function of providing a
temporary abode of purchasing power.”

Money can act as a temporary abode of purchasing power if it is kept in the form of cash,
demand deposits or any other asset which is close to currency, i.e., time deposits. This approach
lays emphasis on the store of value function of money and provides a broader measure of money.

3. Gurley and Shaw Approach:

Gurley and Shaw further widened the scope of money supply by including in its constituents
currency plus demand and time deposits of banks plus the liabilities of non-banking
intermediaries. The liabilities of non-banking intermediaries cover saving bank deposits, shares,
bonds, etc. and are close substitutes to money.
4. Radcliffe Committee Approach:
Radcliffe Committee approach or liquidity approach provides much wider view of the concept of
money supply. In this approach, the concept of money supply is viewed in terms of general
liquidity of the economy.

Money supply covers “the whole liquidity position that is relevant to spending decisions.” The
spending is not limited to the amount of money in existence. It is related to the amount of money
people think they can get hold of whether by receipts of income, by disposal of assets or by
borrowing.

Thus, according to this approach, money supply includes cash, all kinds of bank deposits,
deposits with other institutions, near-money assets and the borrowing facilities available to the
people.

The practical difficulty with this liquidity approach is that the money supply in this wider sense
cannot be successfully measured because the degree of liquidity of different constituents of
money supply varies considerably.

Moreover, most of the constituents remain outside the control of central bank and thus restrict
the effective implementation of monetary policy.

Money Multiplier:

The money multiplier is the amount of money that banks generate with each dollar of
reserves. The money multiplier describes how an initial deposit leads to a greater final increase
in the total money supply. Also known as “monetary multiplier,” it represents the largest degree
to which the money supply is influenced by changes in the quantity of deposits. It identifies the
ratio of decrease and/or increase in the money supply in relation to the commensurate decrease
and/or increase in deposits.

Let’s explain this way, in terms of our banking system: in a system of fractional reserve banking,
commercial banks must only retain a particular fraction of their deposits in reserves. The reserve
ratio is whatever that fraction is.

In this system, the majority of the money supply is generated by such banks, because they only
have to hold some of their deposits as reserves; when these banks make loans using the rest of
their deposits, this result in the creation of new money. The money multiplier is the greatest
amount of money that can be created through this kind of banking.

Money Multiplier Formula

The money multiplier is equal to the change in the total money supply divided by the change in
the monetary base (the reserves). Here that is represented as a formula:
Money multiplier = Change in total money supply ÷ Change in the monetary base

How to Calculate the Money Multiplier:

As you now know, the money multiplier is the amount of money generated by the banking
system with a certain amount of their reserves (say, one dollar). The amount of money generated
here is determined by the reserve ratio. Let’s call the reserve ratio “R.” The money multiplier is 1
÷ R, being the inverse of the reserve ratio.

Money multiplier = 1 ÷ R
Using this equation, you’ll find that a higher reserve ratio means a lower money multiplier, and
likewise, a lower reserve ratio means a higher money multiplier.

Example of money multiplier:

Let’s say your reserve ratio is 10% or 0.1 in decimal form. If we plug that into the equation
above, it looks like this:

Money multiplier = 1 ÷ 0.1

Thus, the money multiplier equals 10.

What does this mean in practice? If someone deposits $50, the bank must reserve 10% of that
$50, or $5 total. Then, the bank lends out $45. Then other banks experience deposits of $45, of
which $4.50 is retained and $40.50 is lent out. And this cycle continues… see the table below for
the continuation of this example:

Step # $ deposited $ reserved $ lent out by bank Total deposits so far

1 $50 $5 $45 $50

2 $45 $4.50 $40.50 $95

3 $40.50 $4.05 $36.45 $135.50

4 $36.45 $3.64 $32.81 $171.95

5 $32.81 $3.28 $29.53 $204.76

6 $29.53 $2.95 $26.58 $234.29

7 $26.58 $2.66 $23.92 $260.87

8 $23.92 $2.39 $21.53 $284.79

9 $21.53 $2.15 $19.38 $306.32

10 $19.38 $1.94 $17.44 $325.70

Totals $325.70 $32.56 $293.14 Ends at $325.70