Ch3 Concept Of Money Supply Flashcards
Q1) it is important to know two things about any measure of money supply. What are they ?
🔷The supply of money is a stock variable i.e. it refers to the total amount of money at any particular point of time. It is the change in the stock of money (say, increase or decrease per month or year), which is a flow.
🔷The stock of money always refers to the stock of money available to the public as a means of payments and store of value. This is always smaller than the total stock of money that really exists in an economy.
Q2) what is rationale of measuring money supply ? Or why empirical analysis of money supply is important ?
🔷 empirical analysis of money supply is important for two reasons :
- It facilitates analysis of monetary developments in order to provide a deeper understanding of the causes of money growth.
- It is essential from a monetary policy perspective as it provides a framework to evaluate whether the stock of money in the economy is consistent with the standards for price stability and to understand the nature of deviations from this standard. The central banks all over the world adopt monetary policy to stabilise price level and GDP growth by directly controlling the supply of money. This is achieved mainly by managing the quantity of monetary base.
The success of monetary policy depends to a large extent on the controllability of money supply and the monetary base.
Q3) what are the sources of money supply or define money supply?
The supply of money in the economy depends on:
(a) the decision of the central bank based on the authority conferred on it
(b) the supply responses of the commercial banking system of the country to the changes in policy variables initiated by the central bank to influence the total money supply in the economy.
🔷The central banks of all countries are empowered to issue currency .
🔷It is therefore , the central bank is the primary source of money supply in all countries.
🔷In effect , high powered money issued by monetary authorities is the source of all other forms of money.
🔷The currency issued by the central bank is ‘fiat money and is backed by supporting reserves and its value is guaranteed by the government.
🔷The currency issued by the central bank is, in fact a liability of the central bank and the government.
🔷The second major source of money supply is the banking system of the country.
🔷 Banks create money supply in the process of borrowing and lending transactions with the public. Money so created by the commercial banks is called ‘credit money’ .
Q4) define M1 M2 M3 and M4 measurement of money supply ? Describe the different components of money supply?
M1 = Currency notes and coins with the people + demand deposits of banks ( current and saving deposit accounts ) + other deposits with the RBI.
M2 = M1 + savings deposits with post office savings banks.
M3 = M1 + net time deposits with the banking system.
M4 = M3 + total deposits with the Post Office Savings Organization (excluding National Savings Certificates).
Q5) define reserve money?
🔷Reserve Money = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI = Net RBI credit to the Government + RBI credit to the Commercial sector + RBI’s Claims on banks + RBI’s net Foreign assets + Government’s Currency liabilities to the public - RBI’s net non - monetary Liabilities.
🔷Reserve money, also known as central bank money, base money or high-powered money, needs a special mention as it plays a critical role in the determination of the total supply of money.
🔷Reserve money determines the level of liquidity and price level in the economy and, therefore, its management is of crucial importance to stabilize liquidity, growth, and price level in an economy.
Q6) define four new monetary aggregates on the basis of the balance sheet of the banking sector in conformity with the norms of progressive liquidity?
🔷Reserve Money = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI = Net RBI credit to the Government + RBI credit to the Commercial sector + RBI’s Claims on banks + RBI’s net Foreign assets + Government’s Currency liabilities to the public - RBI’s net non - monetary Liabilities.
🔷NM1 = Currency with the public + Demand deposits with the banking system + ‘Other’ deposits with the RBI.
🔷NM2 = NM1 + Short-term time deposits of residents (including and up to contractual maturity of one year).
🔷NM3 = NM2 + Long-term time deposits of residents + Call/Term funding from financial institutions.
Q7) what are close substitute of money issued by the non banking financial institutions which are included in liquidity aggregates?
L1= NM3 + All deposits with the post office savings banks (excluding National Savings Certificates).
L2= L1 +Term deposits with term lending institutions and refinancing institutions (Fls) + Term borrowing by Fls + Certificates of deposit issued by FIs .
L3 = L2+ Public deposits of non-banking financial companies
Q8) there are two alternate theories in respect of determination of money supply. What are they ?
🔷According to the first view, 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 activities which affect people’s desire to hold currency relative to deposits, rate of interest, etc.
🔷The current practice is to explain the determinants of money supply based on ‘money multiplier approach’ which focuses on the relation between the money stock and money supply in terms of the monetary base or high-powered money.
🔷This approach holds that total supply of nominal money in the economy is determined by the joint behaviour of the central bank, the commercial banks and the public.
Q9) what are the concept of money multiplier? What is the nature of relationship between money multiplier and money supply?
🔷 the money supply is defined as: M= m X MB
where , M is the money supply, m is money multiplier and MB is the monetary base or high powered money.
🔷 Money multiplier ‘m’ is defined as the ratio that relates the change in the money supply to a given change in the monetary base.
🔷 From the above equation we can derive the money multiplier (m) as :
Money Multiplier (m) = money supply
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Monetary base
🔷 The multiplier indicates what multiple of the monetary base is transformed into money supply.
🔷the multiplier process operates as long as banks have excess reserves. if some portion of the increase in high powered money finds its way into currency , this portion does not undergo multiple deposit expansion .
🔷 As a rule , an increase in the monetary base that goes into currency is not multiplied , whereas an increase in monetary base that goes into supporting deposits is multiplied.
Q10) what is the money multiplier approach to supply of money ? Or explain the money multiplier approach to money supply?
🔷The money multiplier approach to money supply propounded by Milton Friedman and Anna Schwartz, (1963) .
🔷It considers three factors as immediate determinants (factors) of money supply, namely:
(a) the stock of high-powered money (H)
(b) the ratio of reserves to deposites, e = (ER/D) and
(c) the ratio of currency to deposit, c ={C/D)
🔷these represent the behaviour of the central bank, behaviour of the commercial banks and the behaviour of the general public respectively.
🔷each of the above contributes to the determination of aggregate money supply in an economy.
a) THE BEHAVIOUR OF CENTRAL BANK:
🔷If the behaviour of the public and the commercial banks remains unchanged over time, the total supply of nominal money in the economy will vary directly with the supply of the nominal high-powered money issued by the central bank.
b) THE BEHAVIOUR OF COMMERCIAL BANKS :
🔷The behaviour of the commercial banks in the economy is reflected in the ratio of their cash reserves to deposits known as the reserve ratio’.
🔷If the required reserve ratio on demand deposits increases while all the other variables remain the same, more reserves would be needed. This implies that banks must contract their loans, causing a decline in deposits held with bank and hence money supply will decrease .
🔷if the required reserve ratio on demand deposits falls, less reserve will be needed, there will be greater expansions of deposits held with the bank and the money supply will increase . Commercial bank can also give more loan.
c) THE BEHAVIOUR OF THE PUBLIC:
🔷 This behaviour of the public is designated as the ‘currency ratio’ .
🔷 The currency deposit ratio shows the the amount of currency that people hold in cash as a proportion of aggregate deposits.
🔷 An increase in cash deposit ratio leads to a decrease in money multiplier and hence decreases the supply of money.
Q11) what is the effect of government expenditure on money supply? Or what is the meaning of ways and means advances (WMA) / overdraft facility ?
🔷Whenever the central and the state governments’ cash balances fall short of the minimum requirement, they are eligible to avail of a facility called Ways and Means Advances (WMA)/overdraft (OD) facility.
🔷 When the Reserve Bank of India lends to the government under WMA /OD, it results in the generation of excess reserves . (EXTRA KNOWLEDGE: here excess reserve means excess money created by RBI)
🔷This happens because when government incurs expenditure, it involves debiting the government balances with the Reserve Bank and crediting the receiver (for e.g., salary account of government employee) account with the commercial bank.
🔷The excess reserves thus created can potentially lead to an increase in money supply through the money multiplier process.
Q12) what is the credit multiplier (deposit multiplier) ? Or define the deposit expansion multiplier? How it is calculated ?
🔷The Credit Multiplier also referred as the deposit multiplier or the deposit expansion multiplier.
🔷it describes the amount of additional money created by commercial bank through the process of lending the available money it has in excess of the central bank’s reserve requirements.
🔷 This measure tells us how much new money will be created by the banking system for a given increase in the high powered money .
🔷 It reflects a bank’s ability to increase the money supply.
🔷The credit multiplier is the reciprocal of the required reserve ratio. If reserve ratio is 20%, then credit multiplier = 1/0.20 = 5.
Credit multiplier = 1
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Required reserve ratio
Q13) difference between deposit multiplier and the money multiplier?
The deposit multiplier and the money multiplier though closely related are not identical because :
a) generally banks do not lend out all of their available money but instead maintain reserves at a level above the minimum required reserve.
b) all borrowers do not spend every Rupee they have borrowed. They are likely to convert some portion of it to cash.
