Determinants of money supply, Managerial Economics


The total supply of nominal money in the economy is determined by the joint behaviour of the central bank which controls the total issue of the high powered money , the commercial banks which by creating credit determine the total amount of nominal demand deposits and the public which by influencing the size of nominal currency in hand is in a position to influence the amount of nominal demand deposition of the commercial banks through affecting their excess cash reserve. We derive here a simple accounting model in order to show how this joint behaviour of the three parties determines the total supply of money in the economy.

Since the total supply of nominal money consists of the currency held by the public and the demand deposits of the commercial banks , the total supply of money held by the public (M) may be denoted as,

M =C+ D


M= the nominal money supply
C= nominal currency, and
D= nominal demand deposits.

The total supply of nominal high powered money issued by the central bank consists of the nominal currency held by the public and the cash reserves held by the commercial banks against their deposit liabilities, i.e.

H=C+ R

H= the nominal supply of the high powered money, and
R= the nominal cash reserves kept by the commercial banks.
By dividing both sides of equation by M by we get

H/M= C/M +R/M

By simultaneously adding and subtracting the term R/D the last term of equation can be rewritten as .

R/M=R/D –R/D +R/M

In the same manner, by multiplying the second term on the right hand side of equation by M/M and the third term by D/D we obtain equation without altering the equality as follows;


Since it follows from equation than (M-D)= C, equationcan be rewritten as


By substituting equation into equation we obtain

H/M= C/M+ R/D- CR/MD

Finally, by dividing both sides of equation by H and taking its reciprocal, we get

M= H/C/M +H/R/D – H/CR/MD

Equation expresses the nominal money supply held by the public in terms of the behaviour of the central banks, commercial banks and the public itself. The behaviour of the central banks is reflected in the supply of the nominal high powered money .given the behaviour of the public and the commercial banks, the total supply of nominal money in the economy will vary directly with the nominal supply of the high powered money is sued by the central banks. The behaviour of the public is determined by the ratio of currency to the money supply C./M designated as the currency ratio Cr. As long as the total nominal money supply consists of the nominal currency and nominal demand deposits, i.e., M= C+ D, the currency ratio will be less than 1.0 . the behaviour of the commercial banks in the economy is reflected in the ratio of their cash reserves to deposits R/D known as the reserves ratio and denoted by the symbol Rr. We know that the central banks in the country has the statutory authority of determining the minimum value of this ratio which is called the minimum legal or required reserves ratio RRr= (RR/D).

In actual practice, however, the commercial banks keep only a part or fraction of their total deposits in the form of cash reserves. Consequently , the value of the reserves ratio Rr is less than 1. However , for the commercial banking system as a whole the actual reserves ratio Rr is greater than the required reserves ratio RRr , since the banks with them a higher than statutorily required percentage of their total deposits in the form of cash reserves.
By substituting the term Cr for the term C/M and the term Rr , for the term R/D in equation we derive the following equation showing the total nominal money supply.

M= H/Cr+ Rr - Cr Rr

Since the value of Cr and Rr is less than unity, the value of their product CrRr must be less than either of the individual values of Cr and Rr. It means than if Cr or Rr increases and H remains constant, the nominal money supply will decrease. Consequently , the conclusion follows that the nominal money supply varies directly with the quantity of the high powered money and inversely with the currency and reserves ratio . although these three variables do not completely explain changes in the nominal money supply nevertheless they serve as useful devices for analysing such changes . consequently, these variables the high powered money (H) the currency ratio (Cr) and the reserves ratio (Rr) are designated as the proximate determinants of the nominal money supply in the economy.

According to the monetarists Milton Friedman, Anna Jacobson , Schwartz, Phillip Cagan, to mention only a few the above method of studying the variable which cause changes in the nominal money supply is very helpful because the determinants are not rigidly linked by either the accounting or the institutional arrangements. In practice, however, some interdependence undoubtedly exists. But whatever small interdependence exists between these three variable it results from certain behaviour on the part of central bank, commercial banks and the public. And it is possible to determine the nature of this interdependence among the three proximate determinants of the nominal money supply by examining the data which measures the actions of the central banks. The commercial banks and the public.

Posted Date: 12/1/2012 5:00:39 AM | Location : United States

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