What is Money Supply?
Money supply is defined as the total money in circulation within the economy during the given period of time. It is the stock variable determined by the joint behavior of the general public, BIFs, Government and the policy of the central bank. Among them, 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:
- Narrow Money Supply (M1) ⇒ Cash + Demand Deposit
- Broad Money Supply (M2) ⇒ M1 + Total Deposit
Nepal Rastra Bank (NRB), as a central bank, is responsible for determining the money supply in Nepal. Since the basic objective of NRB is to maintain the stability and growth, NRB determines the money supply to achieve these objectives. To achieve the objectives of growth and stability, NRB should maintain money market equilibrium (i.e., Md = Ms).
If md>ms, then there is a shortage of liquidity in the market, which increases the interest rate and reduces consumption and investment. So, the aggregate demand declines, and the economy is not able to achieve growth and stability objectives due to a shortage of liquidity in the market.
If money demand > money supply ⇒ interest rate ↑⇒ Consumption & Investment ↓ ⇒ Aggregate demand ↓, Output ↓, Price ↓
If md < ms, then there is excess liquidity in the market, which reduces the interest rate and increases consumption & investment demand. This increases the aggregate demand and creates inflationary pressure in the economy. So, the central bank is not able to maintain stability. This means NRB should regulate the money supply to maintain Md = Ms.
Since money demand is the public choice variable, it is assumed to be stable by the central bank. So, the NRB estimates the money demand function using the time series data, assuming that money demand and money supply were equal in the past. Then NRB estimates the following money demand function.
Md = F (Y,P,r) ———— (i)
Where
- Y = GDP on income
- P = Price level
- r = Interest rate
It is assumed that Md is positive and proportional to P, then NRB estimates the money demand function as:
Md = P.f(Y,r) ———– (ii)
By estimating this money demand function, NRB finds the income and interest elasticity of money demand. NRB has pre-defined growth target and inflation target, then the required growth rate of money supply to achieve the objectives is estimated as:
Required growth rate of money supply = g*.ηy +P’* – ηr.Δr*
Where
- g*= targeted economic growth
- P’* = targeted inflation
- ηy = income elasticity of Md
- ηr = interest elasticity of Md
- Δr* = change in targeted interest rate
This is the required growth rate of the money supply in order to achieve the inflation and economic growth target. Then, NRB estimates the trend of money supply growth based on some assumptions. If the estimated growth and the required growth of the money supply are the same or close to each other, then NRB does not change any policy instruments. If such an estimated and required growth rate of money supply differs significantly, then NRB changes the policy instruments to achieve the required growth rate of money supply.
For example, if the estimated growth rate is higher than required, then NRB uses contractionary policy instruments such as an increase in CRR, SLR, Bank Rate, etc.
Once the NRB determines the required growth rate of the money supply, it regularly observes the market and intervenes if necessary to maintain the required growth rate of the money supply.
Related Notes