Money supply is defined as the total money in circulation within the economy during the given period. It is the stock variable determined by the joint behavior of the general public, BFIs, government, and the policy of the central bank. Among them, the central bank’s policy is said to be dominant in determining money supply, and so money supply is known as a policy choice variable.
For policy making and accounting, the money supply can be classified as:
1. Narrow Money Supply (M1)
M1 = Cash + Demand Deposit (C +DD)
2. Broad Money Supply (M2)
M2 = M1 + Time Deposit or C + DD + TD
M3 =M2 + Forex =C + DD + TD + Forex
Where
- C = Cash held by the public
- DD = Demand deposit (savings & current A/C, chequeable deposit)
- TD = Time deposit (Investable fund/investable demand for money)
- Forex = Foreign exchange
Determinants of Money Supply
Such factors affecting money supply can be shown as:
#High Power Money
It is the major determinant of money supply, where H is the sum of cash held by the public and total reserves in the banking system. The high power theory of money supply shows that there is a positive relationship between money supply and H. Different factors affect H from both the supply and demand sides, and these factors also affect money supply. The major factors affectingthe money supply related to H are:
- Net foreign assets (NFA)
- Net credit to government (NCG)
- Credit to the government enterprises (CGE)
- Credit to the Commercial banks (CCB)
- Credit to the public sectors (CPS)
- CP = Cash held by the public
- RG = Reserve of Government with the central bank
- RCB = Reserve of commercial banks with the central bank
- VCCB = Vault cash of commercial banks
- RPS =Reserve of the private sector with commercial banks
#Money Multiplier
There is a positive relationship between money supply and money multiplier, where the money multiplier is the numerical value that shows by how many times money supply increases due to an increase in one unit of high-powered money (M). Different behavioral ratios affect the value of the money multiplier. These ratios are the factors affecting money supply, and they are:
- C/DD <0
- R /DD < 0
- TD/DD >0
#Other factors
In addition to the high power money and money multiplier, there are other behavioral, institutional, and structural factors affecting the money supply. Among them, the major factors are
- Spending and saving behavior of the society.
- Nature and status of the financial market development.
- Socio-cultural factors.
- Seasonal factors.
- Financial access, innovation, and financial literacy.
- Government’s deficit financing, policies, and spending capacity.
- External factors such as foreign trade, investment, and employment.
Theories of Money Supply
Theories of Money Supply explain how the quantity of money in an economy is determined and who controls it. In economics, money supply theories mainly focus on the role of the central bank, commercial banks, and the public.
High power (H) theory of money supply
The H theory shows that there is a positive relationship between the money supply and the high power of money. i.e.
Ms = f (H), f’ >0
The high power money (H) is defined as the money with the power of credit creation and it is given by the sum of the cash hold by the public (C) and the total reserve (R) in the banking system.
i.e. H = C +R
Where
- R = required reserve + Excess reserve
- Required reserve ⇒ CRR, SLR
- Excess reserve ⇒ reserve of other banks
⇒ As the money supply is a positive function of high power money (H), the determinants of H affect the money supply. H has both demand and supply side factors to identify such factors affecting ‘H’, we examine the balance sheet of the central bank. This is why it is also called a balance sheet approach to money supply.
Assets = Liabilities
Or, monetary assets (MA) + Non-monetary assets (NMA) = Monetary Liabilities (ML) + Non-monetary liabilities (NML)
Here, the monetary assets (MA) represent the source of supply of ‘H’ higher power money and consist of:
MA = NFA+ NGC + CGE + CCB + CPS
Where
- NFA = Net foreign assets
- NCG = Net credit to Government
- CGE = Credit to Government enterprise (Nepal Airlines, NEA)
- CCB = Credit to commercial banks
- CPS = Credit to the private sectors
There is a positive relationship between money supply and these supply-side factors of H. For example, if NFA increases due to the increase in inflow of remittance, it increases the money supply in the economy. Similarly, if the government borrows more money from the central bank, it increases the money supply in the market. The same relationship of money supply with the other supply-side factors of H.
The monetary liabilities (ML) of the central bank represent the demand or use of H, and it consists of:
ML = CP + RG + RCB + VCCB + RPS
Where,
- CP = Cash held by the public
- RG = Reserve of Government with the central bank
- RCB = Reserve of commercial banks with the central bank
- VCCB = Vault cash of commercial banks
- RPS =Reserve of the private sector with commercial banks
These demand-side factors of H and money supply are inversely related. For example, if people start holding more cash (CP↑), it reduces the circulation of money and the money supply in the economy. If the government is unable to spend and the reserve in the central bank increases (RG↑), it reduces the money supply in the economy. Similarly, the relationship of money supply with other factors affecting H from the demand side.
According to this theory, these different factors affect the money supply. Among them, some are exogenous (external), and others are endogenous to the central bank. It means the central bank alone can not control the money supply strictly.
On the supply side, factors of H and NFA depend on the foreign trade, foreign investment, tourism, foreign aid, foreign employement and remittance. These are outside of the control of the central bank.
Similarly, NCG depends on the deficit planning policy of the government, and in developing countries like Nepal, the central bank cannot strictly control it. The central bank can control CGE, CCB, and CPS, which are endogenous to the central bank.
Similarly, on the demand side of H, CP depends on the public choice of holding money, which the central bank can not dictate. Similarly, RG depends on the financial position and spending capacity of the government, which the central bank cannot control.
Cantral Bank can control RCB, VCCB, and RPS only.
This shows that the central bank’s policy alone cannot control the whole money supply because some of the factors are exogenous to the central bank. So, the money supply is determined by the joint behaviour of the general public, government, BFIs, and the policy of the central bank.
Decomposition of high power money = NFA + NCG + CGE + CCB + CPS + CP + RG + CRB+ VCCB + RPS