DETERMINANTS - SUPPLY OF MONEY?

DETERMINANTS OF THE SUPPLY OF MONEY:  
The total credit creation by the banking systems depends upon the number of determinants. Some of the important determinants of the supply of money are:

 1. High Powered Money (H): 

• The high-powered money consists of the currency notes and coins issued by the Government and the Central Bank of the country. 
• The public holds a part of the currency issued and the banks hold a part of these currency reserves of the banks in their own cash vaults and a part is deposited in the Central Bank in the Reserve Accounts. 
• Accordingly, the high-powered money can be obtained as sum of currency held by the public and the part held by the banks as reserves. 
• Thus, high powered money is a sum of currency held by the public and the part held by the banks as reserves. 
• Thus, H = Cp + R, Where, H = the amount of high-powered money, Cp = the amount of high-powered money, C = Currency held by the public, R = Cash Reserves of currency with the banks. 
• The central bank and Government are producers of the high-powered money and the commercial banks do not have any role in producing this high-powered money (H). 
• However, commercial banks are producers of demand deposits that are also used as money (H). But for producing demand deposits or credit, banks have to keep with themselves cash reserves of currency. 
• Since these cash reserves with the banks serve as a basis for the multiple creations of the demand deposits that constitute an important part of total money supply in the economy, it provides high-power to the currency issued by the Central Bank and Government. 
• It is against these cash reserves that banks are able to create a multiple expansion of credit or demand deposits due to which a large expansion in money supply in the economy takes place. 

2. Excess reserves: 

• The excess reserves available with the banking system to a large extent determine the credit-creating capacity of banks. 
• The amount of deposit created varies directly with the amount of excess reserve. 
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3. Banking habits of the people: The banking habits of the people of a country also determine the credit creating capacity of the commercial banks. In industrially advanced countries the banking habits of the people are well developed and most of the transactions are settled through cheques. Evidently, the credit creating capacity of the commercial banks is higher in such countries. In developing countries like India just the opposite is true. Banking facilities are hardly available in most rural areas where 70% of the people of the country live. Moreover, banking habits are not well developed in such countries. In fact the prevalence of the barter system and lack of monetization in most developing countries of Asia, Latin America and Africa obstruct multiple credit expansion in the banking system. 

4. Reserve Ratio: The reserve ratio maintained by the banking system as a whole also determines the amount of maximum credit, which can be created by the banks. If the central bank raises the minimum reserve ratio, then the amount of deposit created by the banking system as a whole will fall. The reverse is also true.

 5. Existing Business Conditions: The amount of credit to be created by the banking system as a whole depends on the state of the economy, or, on the existing business conditions. In an expanding economy, there will be more demand for goods and services. As a result profit prospects will be bright. So business community will be eager to produce more because they can sell more. Hence they will take more loans and the demand for bank loan will expand. This will make it profitable for the banks to expand the volume of credit. In contrast, if the economy is in depression banks cannot create much credit. It is because there will not be much demand for bank loan in such times.

 6. Availability of collateral securities: Banks normally asked for securities for extending loans. If the borrowers do not have sufficient acceptable securities to offer then the total amount of deposits created by the banking system will be low. Even if banks are curious to lend, they cannot increase their volume of loan. 

7. Legal Reserves: If the legal reserve is 10% but commercial banks keep 20% reserve, the deposit (credit) multiplier will be 5 and not 10. Thus, if there is an initial increase in cash deposit of a bank of, say, $1000, the total increase in bank deposit at the end will be only $5,000 and not $10,000. This is what happens in countries like India having underdeveloped money markets. 

8. Expansion of the banking system: The expansion of a country’s banking system also determines the total amount of credit created. A developed banking system and wide spread banking branches will lead to expansion of credit creating capacity of the banks. It is because the total amount of credit that can be created by the banking system as a whole is a multiple of the total excess reserves of the banking system. But a single (monopoly) bank in the system cannot create credit exceeding its own excess reserves. 

9. Cash leakage: The withdrawal of a certain amount of money by the depositors for spending purposes, the banks will be left with less cash for credit creation. Thus, if the people’s demand for money increases, the amount of cash with the non-bank public will also increase. This will reduce the credit-creating capacity of the commercial banks. Thus the capacity of commercial banks to create credit depends not only on their own cash requirements but also on the cash requirement of the public or of the non-banking system. Their own cash requirements depend mainly on the monetary policy of the central bank. The central bank often restricts money supply growth in order to slow down the economy and control inflation. But the cash requirement of the public depends on transactions demand for money.