Money Supply: Definition, Factors affecting Money Supply, High Powered Money and Money Multiplier.

Money supply shows the stock of money in the economy at a certain point of time. It can be derived by adding the total financial assets along with the currency in circulation that can perform functions of money.

Money supply can be broadly divided into narrow money (M1) and broad money (M2).

Narrow Money Supply (M1):

Narrow money supply covers the currency held by the non bank public (CP) plus the demand deposits (DD) held at the banks and financial institutions (BFIs). Demand deposits, also called as the checkable deposits, refer to the deposits maintained at the current account of the BFIs. This measure of money supply is the highly liquid measure of money supply as the balances maintained in demand deposits can be instantly converted into cash. 

Broad Money Supply (M2):

Board money supply includes the deposits maintained in the form of time deposits (TD) in addition to the demand deposits and currency at the hands of the non-bank public. In the context of Nepal, time deposits include the deposits maintained at saving, fixed, call and margin deposits accounts at the BFIs. Since there are some restrictions for converting the money balances held in the form of time deposits into cash instantly, this definition is also called less liquid definition of money supply.

Besides the narrow and broad measures of money supply, one another measure of money supply is also measured in Nepal. It is called broad money liquidity and includes the deposits maintained in foreign currencies. However, this measure has not been used extensively used in policy analysis yet.

The supply of money in the economy mostly affects the interest rate and the price level. If money supply is in excess of demand, the economy is likely to be overheated and inflationary pressure is likely to be created. On the other hand, if money supply is deficient, interest rate goes up discouraging the economic activities like production and consumption. It is thus necessary that the monetary authority uses appropriate policies to keep the supply of money at desirable level.

In order to understand and analyze the money supply process, the following two approaches are used:

Money Multiplier Approach

This is the theoretical approach to understand the money supply process. According to this approach, money supply is determined by the joint interaction of money multiplier (m) and reserve money (RM). Money supply (Ms) can be expressed as the product of money multiplier and reserve money.

In other words, 

Where, M^s is the money stock, m is the value of money multiplier and RM is the reserve money or monetary base.

Reserve Money (RM)

This measure of money supply is also called the base money or high powered money. It is so called because the banking system can create further money supply by making changes on its monetary base. It is the base on which the superstructure of money supply is built.

Reserve money includes the cash balances held by the non-bank public in the form of cash (CP), the reserves held by the banks and financial institutions at central bank as required reserves (RR) and the excess reserves held by the BFIs with them in their vaults (ER).

Thus,

RM=CP+RR+ER

To analyze the relationship between base money, money multiplier and the money supply, let us consider the broad definition of money supply. Then,

The total deposits (D) of the banking system (D) consists of demand deposits (DD) and time deposits (TD), then the required reserve to be kept at the central bank can be calculated as :

RR= r percent of total deposits (D); where r = cash reserve ratio

RR = r×D

RR = r×(DD+TD)

Using this definition of RR, the money multiplier relation becomes

Dividing both numerator and denominator by DD gives

Where, r = cash reserve ratio, c = currency-demand deposits ratio, t = time deposit to demand deposit ratio, e = excess reserve to demand deposit ratio.

Now, broad money supply can be expressed as:

This relationship shows that money supply at any point of time is multiplier times the value of monetary base in the economy. The value of multiplier is greater than one. Thus it follows that money supply will always be certain multiple times of the monetary base.

The relationship between the reserve money and money supply can be illustrated with the help of the following graph.

Relationship between Reserve Money and Money Supply

The graph presented above shows that while the currency balances with the public are same in the monetary base as well as money supply, it is the deposits of the banking system that is a multiple of the monetary base.

Factors Affecting Money Supply under Money Multiplier Approach

This analysis shows that the money supply in an economy clearly depends on two broad factors: money multiplier and reserve money. They are called the immediate determinants of money supply.

Money Multiplier

Money multiplier is one of the determinants of money supply. There is a positive and proportionate relationship between money supply and money multiplier i.e. higher the value of money multiplier, higher will be the money supply, given the monetary base. The value of money multiplier depends on the four behavioral ratios: c, r, t and e. The later ratios show the behavior of non-bank public and BFIs and the central bank. Thus, it is often argued that money supply is determined by the joint behavior of public, BFIs and the central bank. In this sense, money supply is not a complete exogenous variable or policy determined variable but partly an endogenous variable as well.

Factor Affecting the Money Multiplier

Currency Deposit Ratio (c)

This ratio shows the preference of the public to hold cash compared to demand deposits. Higher the c ratio, the more cash in relation to the demand deposits will be held by the public. Thus, a higher c ratio will reduce the amount in bank accounts which the bank can lend to the public, thereby creating money supply in the economy. It follows that the c ratio and money multiplier are inversely related.

Determinants of the ‘c’ Ratio

·  Income Level: Higher income level leads to higher bank deposits in general.

·  Banking Access: Increasing access to BFIs leads to less cash holding in general.

·  Illegal Activities: Significant size of illegal activities requires more cash holding.

·   Modern Payment System: With the modernization of the payment system, less cash is required for settling transactions. 

·      Confidence on Banking System: Increasing confidence in the banking system will lead to less cash holding by the public.

 

Required Reserve Ratio (r)

The required reserve ratio is a policy variable whose value is determined by the monetary policy. It shows the behavior of the central bank. When the central bank raises the required reserve ratio, the banks and financial institutions are required to maintain a higher cash balance at the central bank in the form of compulsory reserves as such their lending capacity is reduced. It results in the fall of money multiplier and a contraction in money supply.

Time Deposit Ratio (t)

This ratio shows the preference of the public for holding cash in the form of time deposits compared to the demand deposits. A higher ‘t’ ratio implies that the public wants to keep their balance in fixed deposits rather than the current accounts. It thus shows the preference of the public for time deposits.  This ratio too has inverse relationship with the money multiplier and money supply.

Determinants of ‘t’ Ratio

·  Income Level: High income level may induce people to keep larger cash balance in the form of time deposits.

· Interest Rate on Time Deposits: Higher interest rate on time deposits attracts cash balance to time deposits and the ‘t’ ratio will be higher.

Excess Reserve Ratio (e)

 It shows the amounts of reserves the BFIs want to hold with them as compared to the demand deposits maintained in the banking system. This ratio depends on the interest rate on interbank loans, the bank rate, deposit regularity, and the pattern of bank withdrawals. Higher excess reserve ratio is also translated into reduced lending by the BFIs as such the value of multiplier and money supply will be reduced. In other words, this ratio also has an inverse relationship with the money multiplier.

Determinants of the ‘e’ Ratio

Bank Rate: High bank rate raises the cost of borrowing of the BFIs from the central bank and they maintain higher reserve for meeting the demands of cash balances. It raises the excess reserve ratio.

High Inter-bank Rate: High inter-bank rate raises the cost of borrowing from the inter-bank market. The banks in this case keep sufficient amount of reserves with them to meet the cheque withdrawal demands of the customer that raises the excess reserve ratio. 

Deposits and Withdrawal Patterns: If the deposits are regular and the withdrawals can somehow be predicted, BFIs may reduce the excess reserves maintained in their vaults. Otherwise, the excess reserve ratio will go up.

Reserve Money

Reserve money is the monetary liabilities of the central bank. It is the combination of currency held by the non-bank public; cash in hand of commercial banks, and their deposits with central banks.

 Basically, there are two determinants of reserve money: net foreign assets (NFA) and the net domestic assets (NDA) of the central bank (or monetary authorities).

RM = NFA_MA + NDA_MA

Both NFA and NDA are the balance sheet aggregates of the central bank. Major items of the central bank balance sheet can be grouped as:

Net foreign asset (NFA) + Domestic financial assets (DFA) + Other assets (OA) = Monetary liabilities (ML or Reserve money) + non-monetary liabilities (NML)

Rearranging,

ML= NFA+ DFA+OA-NML

If we net out OA and NML we obtain net non-monetary liabilities,(NNML).

RM = NFA_MA + NDA_MA    ; where NDA_MA =DFA+OA-NML

Net Foreign Asset of NRB

NFA_MA is the summary result of the net transactions of Nepal with the rest of the world. It is more or less autonomous factor affecting money supply.

NDA_MA is the domestic source of the monetary base that can be expressed as the sum of:

Net Claims on Government (NCG)

It arises from the borrowing of the government from the central bank. The central bank may buy the government securities or provide overdraft facility to the government. Whatever method is applied, credit will be provided to the government that will result in a higher monetary base. If the central bank is forced to hold the government securities and lend to the government in the event of budget deficit, it is known as autonomous component and is not under the control of the central bank. On the other hand, if the central bank itself actively buys and sells government securities, it can be taken as the discretionary component in the NCG.

Credit to Public Enterprises (CPE)

The central bank may also provide credit to public enterprises. Such credit raises the domestic asset of the central bank as well as the monetary base. Such lending may be more or less discretionary.

Credit to Commercial Banks (CCB)

The central bank also provides refinance facilities to the commercial banks. Banks can rediscount government securities at the central bank and they can also get refinance against their priority sector and export lending. This type of lending is a discretionary component of the monetary base as the central bank can control such lending as per its policy stance.

Credit to Private Sector (CP)

Central bank does not provide credit to the private sector in general. However, it may provide loans to its staff. Such credit is relatively small in amount and is not very significant for the purpose of policy analysis.

It follows from the discussion that, just like the money multiplier, the central bank cannot control the monetary base completely. In other words, changes in the monetary base are both autonomous and discretionary. The NFA of monetary authority depends upon balance of payments of the country and is largely exogenous. Thus, it can be taken as an autonomous factor for driving the money supply. Even though, in case of Nepal, the central bank can buy and sell foreign exchange to bring changes in the NFA, it is forced to keep the exchange rate fixed. Thus, it is compelled to interene the market for managing the exchange rate rather than for bringing discretionary changes in the monetary base.

The domestic component of the money supply also has autonomous and discretionary components. The NRB financing to the government is somewhat autonomous as the government can take overdraft up to 5 percent of the revenue mobilized in the previous fiscal year. However, NRB can play in the open market operations so as to bring some discretionary changes in the monetary base. Other changes in the monetary base arising from lending to public enterprises and lending to commercial banks can be takes to be largely discretionary i.e. they can be controlled to a large extent by the central bank.

Thus, money supply is also said to be partly autonomous and partly discretionary variable.

The Accounting Approach

The accounting approach to money supply is also known as the balance sheet approach. This approach utilizes the balance sheets of the central bank and commercial banks of the economy to make an analysis of the determinants of money supply.

According to the accounting approach, money supply in an economy can be expressed as the sum total of the net foreign asset and net domestic assets held by the banking system of the economy including the central bank. Thus, there are two major sources of money supply as per this approach: net foreign assets (NFA) and (ii) net domestic assets (NDA).

 Under this approach, money supply can be expressed as below:

M2 = NFA + NDA

Source Side	M2	Uses Side
NFA + NDA		M1 + TD

Where,

NFA = net foreign assets of the monetary sector (foreign assets less foreign liabilities),

NDA = net domestic assets of the monetary sector

M1 = Narrow money

TD = Time Deposits 

NFA implies the total foreign assets less total foreign liability. Foreign assets include gold, reserve fund, SDR holding and foreign exchange reserve of banking system while the foreign liabilities include foreign borrowing by the banking system, foreign deposits maintained at the banking system, etc. Foreign exchange occupies a dominant share in foreign assets.

NDA can be expressed as the sum of net credit availed to the government (NCG), credit provided to non-financial government enterprises (CNFGE), credit provided to financial institutions (CFI) and credit provided to the private sector. (CPvt) adjusted by other items net (OITN).

Thus,

NDA=NCG + CNFGE +CFI+ CPvt – OITN

Change in the claims on government is affected by the government's budgetary position. Such credit will increases with the government financing its budget deficit by taking loans from the banking system. Increase in such credit increases the NDA and increases the money supply too. 

Claims on government enterprises rises when the banking system avails more credit to the public enterprises. Increasing claims on such enterprises will also increase the domestic assets of the banking system and results in an expansion of money supply. 

Credit availed to financial institutions by the banking system is also a part of the domestic assets of the banking system. Increase in such claims has will result in an increase in domestic assets and money supply.

Credit to the private sector by the banking system in the economy shows the expansion of private investment of the economy. Increasing volume of credit to private sector also results into an increase in domestic assets of the system and an increase in money supply. In fact, it is one of the largest components of the money supply.

Factors Affecting Money Supply under Accounting Approach

The accounting approach expresses money supply as the sum of NFA and NDA of the banking system. An increase in NFA and/or NDA will thus result in an increase in money supply. It thus follows that NFA and NDA of the banking system as a whole are the two principle determinants of money supply.

Anything that raises the net foreign assets will help in the expansion of money supply. That is why remittance inflow, capital inflow, FDI, etc have an expansionary impact on money supply.

Likewise increase in the claims on government, claims on government enterprises, and claims on private sector will raise the domestic assets of the banking system and consequently will result in an expansion in money supply.

Just as in the money multiplier approach, we can argue here too that the NFA source of money supply is largely exogenous whereas the domestic sources are partly exogenous and partly policy controlled.

Money Supply in Nepal Few Facts

Money Supply Measures: Size and Growth

• In mid-July 2018, M1 money supply was Rs. 669.4 billion and M2 money supply was 3094.5 billion.
• Over the last 10 years, growth in M1 is 16.0 percent and growth of M2 is 20.2 percent.
• In 2017, the contribution of NFA in M2 was about 40 percent and the contribution of NDA was 60 percent. Over the past few years, the contribution of foreign sources in money supply is falling while the contribution of domestic sources is increasing.

Relative Share of CP, DD and TD in M2

On the uses side, the major component of broad money supply is the time deposits (TD). In 2017, currency with public (CP) contributed 14 percent, demand deposits (DD) contributed 8 percent and time deposits (TD) contributed 78 percent in M2. Thus, M1 covers about one fifth of M2 only.

Over the time the share of CP in M2 is falling and that of TD is rising.

Movement of ‘c’ ratio and’t’ ratio

The currency demand deposit ratio is around 2 percent during the last five years and the t ratio has been increasing over time and has reached about 10 percent in 2017. 

Movement of Money Multiplier

Broad money multiplier is around 4 during the last three years. In July 2018, such multiplier was 4.4.

Conclusion

It follows from the discussion that money supply is not totally fixed by the central bank as assumed by the classical economic models. Rather, it is determined by the joint interaction of the central bank, commercial bank and the public. Furthermore, money supply is broadly determined by money multiplier and the monetary base. While money multiplier remains more or less stable over time, it is the changes in the reserve money that are largely responsible for bringing changes in money supply. This argument is true in case of Nepal. The money supply in Nepalese economy is broadly determined by the exogenous factors in the monetary base.

................................................................................................................................................................