Money supply indigolearn 9 5 concept of money

Money Supply IndigoLearn 9
5. CONCEPT OF MONEY MULTIPLIER
➢ As per the Money Multiplier approach, Money supply is determined as follows
M = m X MB
Where M – Money supply
m – Money multiplier
MB – Monetary base
➢ An increase in the money base (High powered money) increases supply by a multiple.
Increase in supply of money is not just on account of increase in fiat money, but also on
account of a multiplier. This multiplier is determined by the commercial banks and the
public.
5.1.
Money Multiplier Approach To Supply Of Money
➢ This theory is propounded by Milton Freidman and Anna Schwartz.
➢ According to the Money Multiplier approach Three factors that determine money supply:
o Behavior of Central Bank
o Behavior of Commercial banks
o Behavior of General public
1. Behavior of Central Bank –
o Central bank supplies high powered money.
2. Behavior of Commercial Banks
o Commercial banks create credit money through operation of credit multiplier and
credit money increases the total supply of money in the economy. The credit
multiplier is dependent on CRR – i.e. the reserve to deposit ratio.
o If the required reserve ratio increases, more reserves would be needed and banks
must contract their loans, causing decline in further deposits and consequently, a
decline in money supply.
o Generally, banks keep with themselves a percentage higher than the statutorily
required percentage of deposits in the form of cash for the following reasons:
▪ When banks hold money in cash, it has an opportunity cost. The interest
that could have been earned by investing the cash elsewhere is given up.
So if interest rates decrease, opportunity cost goes down and deposits
held as reserve increases and the reserves to deposits ratio also increases.
Banking system’s excess reserves ratio (“e”) is negatively related to the
market interest rate.

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