Money Supply: A Fundamental Economic Pillar
- Article photo, courtesy of CEPR
Money supply is a crucial aspect of any economy, serving as the lifeblood of economic transactions. It refers to the total amount of money circulating in an economy at any given time.
While money plays a vital role in economic stability, both excess and insufficient money supply can have adverse effects, such as inflation or recession. Therefore, it is essential for governments and central banks to regulate and control the money supply based on the needs of the economy. In this article, we will explore the sources of money supply, the measures used to quantify it, and the theory behind money supply, using India as a case study.
Understanding the Sources of Money Supply
The money supply in an economy primarily comes from two sources: the central bank and commercial banks. The central bank, typically the key institution responsible for controlling monetary policy, issues what is known as high power money or reserve money. This money is considered to be the most reliable form of currency as it is backed by government reserves such as gold and foreign currencies.
In addition to the central bank, commercial banks also play a significant role in the creation of money. These institutions generate credit money through borrowing and lending activities with the public. When banks provide loans, they effectively increase the money supply by creating additional deposits in the accounts of borrowers. As a result, both high power money and credit money together contribute to the overall money stock of a country.
While the central bank and commercial banks are the primary contributors to the money supply, non-banking financial intermediaries also play a role, as pointed out by economists Gurley and Shaw. These intermediaries include institutions such as insurance companies and investment firms that contribute to the overall liquidity in the economy.
High Power Money and the Role of the Central Bank
The central bank is tasked with issuing currency and maintaining the reserves that back it. This currency is referred to as high power money because it is supported by the government's reserves, ensuring its value. In most countries, however, the requirement for reserves has been relaxed to a minimum reserve system, where the central bank holds a small fraction of gold and foreign securities as reserves.
For example, in India, the Reserve Bank of India (RBI) follows this system, holding minimal reserves of foreign exchange and gold against the vast amounts of currency in circulation. This managed paper currency system allows the central bank to issue currency as needed while ensuring monetary stability.
The total high power money supply in India is measured by the formula:
H = C + R
Where:
- C = Currency held by the public
- R = Cash reserves held by commercial banks
This measurement captures the total reserve money in circulation and is critical for understanding how much base money the central bank has issued.
Money Creation by Commercial Banks
Commercial banks are the second most important source of money supply. They create credit money through financial transactions such as loans and deposits. When individuals and businesses deposit money in banks, these deposits are referred to as primary deposits. Based on these primary deposits, banks create what are known as secondary or derivative deposits, which expand the money supply.
The process of money creation occurs when banks lend out a portion of the deposits they receive. However, banks are required to keep a portion of the primary deposits as reserves to meet withdrawal demands. There are two types of reserves:
- Statutory Cash Reserve (SCR): Mandated by the central bank to ensure banks hold a certain proportion of their deposits as cash reserves.
- Excess Reserves (ER): Reserves held by the bank beyond the statutory requirement to manage potential withdrawal demands.
The total amount of credit money created by banks depends on several factors:
- The size of primary deposits
- The required reserve ratio
- The demand for loans
- The efficiency of the banking system
As banks lend out money from their deposits, they effectively multiply the money supply through the process of deposit creation. The more deposits banks receive, the more loans they can issue, thus increasing the total money circulating in the economy.
Conclusion
Money supply plays a central role in shaping economic stability. Proper regulation of the money supply is essential to avoid the pitfalls of inflation or economic slowdown. Both the central bank and commercial banks contribute significantly to the money supply, with the former issuing high power money and the latter expanding the supply through credit creation. The ability to measure and control the money supply enables governments and policymakers to adjust monetary policy to support economic growth, manage inflation, and maintain financial stability.
