Table of Content: 

1. INTRODUCTION
2. RATIONALE OF MEASURING MONEY SUPPLY
3. MEASUREMENT OF MONEY SUPPLY
4. THE MONEY MULTIPLIER APPROACH TO SUPPLY OF MONEY 
5. MONETARY POLICY AND MONEY SUPPLY

INTRODUCTION

Money as a means of payment and thus a lubricant that facilitates exchange. Irrespective of the form of money, in any economy, money performs three primary functions – a medium of exchange, a unit of account, and a store of value. Money as a medium of exchange may be used for any transactions wherein goods or services are purchased or sold. Money as a unit of account can be used to value goods or services and express it in monetary terms. Money can also be stored or conserved for future purposes.

In the real world, however, money provides monetary services along with tangible remuneration. It is for this reason that money must have a relationship with the activities that economic entities pursue. Money can, therefore, be defined for policy purposes as a set of liquid financial assets, the variation in the stock of which could impact aggregate economic activity.

Economic stability requires that the supply of money at any time should to be maintained at an optimum level. A pre-requisite for achieving this is to accurately estimate the stock of money supply on a regular basis and appropriately regulate it in accordance with the monetary requirements of the country.

RATIONALE OF MEASURING MONEY SUPPLY

The empirical analysis of the money supply is important for two reasons:
1. It facilitates analysis of monetary developments in order to provide a deeper understanding of the causes of money growth. 

2. 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 the monetary base and the money supply.

MEASUREMENT OF MONEY SUPPLY

There is virtually a profusion of different types of money, especially credit money, and this makes measurement of money supply a difficult task. Different countries follow different practices in measuring money supply. The measures of money supply vary from country to country, from time to time and from purpose to purpose. Reference to such different measures is beyond the scope of this unit. Just as other countries do; a range of monetary and liquidity measures are compiled and published by the RBI. Money supply will change if the magnitude of any of its constituents changes.

Since July 1935, the Reserve Bank of India has been compiling and disseminating monetary statistics. Till 1967-68, the RBI used to publish only a single ‘narrow measure of money supply’ (M1) defined as the sum of currency and demand deposits held by the public. From 1967-68, a 'broader' measure of money supply, called 'aggregate monetary resources' (AMR) was additionally published by the RBI. From April 1977, following the recommendations of the Second Working Group on Money Supply (SWG), the RBI has been publishing data on four alternative measures of money supply denoted by M1, M2, M3 and M4 besides the reserve money. The respective empirical definitions of these measures are given below:

THE CONCEPT OF MONEY MULTIPLIER

The money created by the Reserve Bank of India is the monetary base, also known as high￾powered money. Banks create money by making loans. A bank loans or invests its excess reserves to earn more interest. A one-rupee increase in the monetary base causes the money supply to increase by more than one rupee. The increase in the money supply is the money multiplier.
The money supply is defined as 
Money is either currency held by the public or bank deposits: M = C + D.

Where M is the money supply, m is the money multiplier and MB is the monetary base or high-powered money. From the above equation, we can derive the money multiplier (m) as

Money multiplier m is defined as a ratio that relates the changes in the money supply to a given change in the monetary base. It is the ratio of the stock of money to the stock of high-powered money. 

THE MONEY MULTIPLIER APPROACH TO SUPPLY OF MONEY 

The money multiplier approach to money supply propounded by Milton Friedman and Anna Schwartz, (1963) considers three factors as immediate determinants of money supply, namely: 
(a) the stock of high-powered money (H)
(b) the ratio of reserves to deposits or reserve-ratio r = {Reserves/Deposits R/D} and 
(c) the ratio of currency to deposits, or currency-deposit ratio c={C/D}

You may note that these represent the behaviour of the central bank, behaviour of the commercial banks and the behaviour of the general public respectively. We shall now describe how each of the above contributes to the determination of aggregate money supply in an economy. 

a) The Behaviour of the Central Bank

The behaviour of the central bank which controls the issue of currency is reflected in the supply of the nominal high-powered money. Money stock is determined by the money multiplier and the monetary base (H) is controlled by the monetary authority. 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 

By creating credit, the commercial banks determine the total amount of nominal demand deposits. 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 and hence in the money supply. If the required reserve ratio falls, there will be greater expansions of deposits because the same level of reserves can now support more deposits and the money supply will increase. To sum up, smaller the reserve ratio larger will be the money multiplier.  

In actual practice, however, the commercial banks keep only the required fraction of their total deposits in the form of cash reserves. However, for the commercial banking system as a whole, the actual reserves ratio may be greater than the required reserve ratio since the banks keep a higher than the statutorily required percentage of their deposits in the form of cash reserves as a buffer against unexpected events requiring cash.

c) The Behaviour of the Public

As we know, demand deposits undergo multiple expansions while currency in your hands does not. Hence, when bank deposits are being converted into currency, banks can create only less credit money. The overall level of multiple expansion declines, and therefore, money multiplier also falls. Hence, we conclude that money multiplier and the money supply are negatively related to the currency ratio c.

The currency-deposit ratio (c) represents the degree of adoption of banking habits by the people. This is related to the level of economic activities or the GDP growth and is influenced by the degree of financial sophistication in terms of ease and access to financial services, availability of a richer array of liquid financial assets, financial innovations, institutional changes etc.

The smaller the currency-deposit ratio, the larger would be the money multiplier. This is because a smaller proportion of high powered money is being used as currency and therefore, a larger proportion is available to be reserves which get transformed into money. The time deposit-demand deposit ratio i.e. how much money is kept as time deposits compared to demand deposits, also has an important implication for the money multiplier and, hence for the money stock in the economy. An increase in TD/DD ratio means that greater availability of free reserves and consequent enlargement of volume of multiple deposit expansion and monetary expansion.

MONETARY POLICY AND MONEY SUPPLY

If the central bank of a country wants to stimulate economic activity it does so by infusing liquidity into the system. Let us take the example of open market operations (OMO) by central banks. Purchase of government securities injects high powered money (monetary base) into the system. Assuming that banks do not hold excess reserves and people do not hold more currency than before, and also that there is demand for loans from businesses, the credit creation process by the banking system in the country will create money to the tune of

The effect of an open market sale is very similar to that of open market purchase, but in the opposite direction. In other words, an open market purchase by central bank will reduce the reserves and thereby reduce the money supply. 
Is it possible that the value of money multiplier is zero? It may happen when the interest rates are too low and the banks prefer to hold the newly injected reserves as excess reserves with no risk attached to it. 

EFFECT OF GOVERNMENT EXPENDITURE ON MONEY SUPPLY

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 governments under WMA /OD, it results in the generation of excess reserves (i.e., excess balances of commercial banks with the Reserve Bank). 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.