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, Ms 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 = NFAMA
+ NDAMA
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 = NFAMA
+ NDAMA ; where NDAMA
=DFA+OA-NML
Net
Foreign Asset of NRB
NFAMA 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.
NDAMA 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.
................................................................................................................................................................
3 comments:
Great Blog Bro.. I am preparing for the exam it has help me alot in my studies. Thanks alot.
Thank you for a detailed explanation.
Awesomme blog you have here
Post a Comment