THEORY OF MONEY SUPPLY The supply of money supply is determined jointly by the monetary authority, banks and the

public. There is a distinction between two kinds of money: (a) Ordinary money [M] and (b) High powered money [H]. M is defined narrowly as the sum of currency and demand deposits of banks [including the RBI] held by the public; and that since other deposits of the RBI included in the measure of M are a very small proportion [less than one per cent] of the total money supply of M, other deposits of the RBI is ignored for theoretical simplification. Accordingly, (1)

High powered money [H] is money produced by the RBI and the GoI [small coins including one rupee notes] and held by the public and banks. The RBI calls H Reserve Money. H is the sum of (i) currency held by the public [C], (ii) Cash reserves of banks [R], and (iii) Other deposits of the RBI [OD]. (2) is common to both M and H and that the only difference between the latter two is due to the second component of each, namely DD in M and R in H. This difference arises from the presence of banks as the producers of demand deposits. But to be able to produce DD, banks have to maintain R, which is a part of H, produced only by the monetary authority and not by banks themselves. A. THE H THEORY OF MONEY SUPPLY us As a first approximation, it is assumed that the supply of H [Hs] is policy determined. This assumption gives where the bar above H signifies that it is given exogenously to the public and banks. The analysis of the demand for H [Hd] is much more important for the H theory. The key insight of the theory is to relate it DD or M. H is demanded partly by the public as currency [C] and partly by the banks as reserves [R]. These are the only two sources of demand for H in this model. The demand for C [Cd] as a component of M is affected largely by the same factors as affect the demand for M, such as level of income and the rate of interest, among other things. The same is true of the demand for DD [DDd]. Therefore as a first approximation, it is reasonable to assume that Cd and DDd will be highly correlated-that Cd will be a proportional function of DD. This may be expressed as (4) c, then, is the ratio of Cd to DD. In short, it is the desired currency-deposit ratio of the public. c itself will express the preferences of the public as between currency and demand deposits of banks. Therefore c is a behavioural ratio. But it is assumed to be a constant in this model. The reserves of banks are usually divided under two heads: (a) required reserves [RR] and (b) excess reserves [ER]. Required reserves are reserves which banks are required statutorily to hold with the RBI. Banks have no choice about them. Under the law, the RBI empowered to stipulate the statutory reserve ratio, which may be varied between 3 per cent and 15 per cent of the total demand and time liabilities of a bank. Every scheduled bank is required to maintain all its RR as balances with the RBI. All reserves in excess of RR are called ER. Banks are free to hold them as cash on hand also called [vault cash] with themselves or as balances with the RBI. Banks hold ER voluntarily. They are held to meet their clearing drains [i.e., net loss of cash due to crossclearing of cheques among banks] as well as currency drains [i.e., net withdrawal of currency by their depositors]. These drains are partly expected and partly unexpected, giving rise to what may be called banks transactions and precautionary demand for cash reserves. We hypothesize that ERd will be determined largely by the banks total liabilities. (3)

Thus both RR and ER and so Rd become increasing functions of the total demand and time liabilities of banks. The demand and time liabilities of banks are predominantly [about 92%] due to the demand and time deposits from the public. Therefore as a simplification, say that Rd is largely a proportional function of the total deposits of the banks: (5) r, then is the ratio of Rd to total deposits of banks. For short, it is called reserve-deposit ratio. It is assumed that bank deposits are of two kinds- demand deposits [DD] and time deposits [TD]. The former are counted as money; the latter not. The division between DD and TD is decided by the public, given the terms and conditions on which banks are willing to sell the two kinds of the deposits to the public. In other words, it is the public who decides how much TD to hold in relation to DD. Again, as a simplification, it is hypothesized that TDd is an increasing proportional function of DD. (6) (7) t is the ratio of TDd to DD. It is called as time-deposit ratio. From equation (7) and from (6) we get

( From equation (5) & (8) ( Recalling that

(8)

(9)

, from equation (4) & (9) we have ( ( ) ) (10)

Thus Hd has been expressed as a function of DD and three behavioural ratios c, t and r. The market for H will be in equilibrium when Hd=Hs or from equation (3) & (10) when ( )

The above equation can be solved for DD

( )

(11)

The above equation gives the equilibrium value of DD in terms of H and the three behavioural ratios c, t and r.
( )

is called the demand deposit multiplier. Next, from equation (1) & (4) and assuming that C=Cd, we have

(
(

)
)

(12)

The above is the key equation of the H theory of money supply. It makes the supply of money a function of H and the three behavioural ratios, c, t and r. The expression gives the value of what is known as the money ( ) multiplier, . Then, the equation (12) can be written as The H theory of money supply is popularly called the money multiplier theory of money supply. The equation says that the determinants of the money supply of M can be classified under two main heads: (a) those that affect H and (b) those that affect . From the theory it is clear that whereas changes in H are largely policy-controlled, changes in are largely endogenous, i.e. are such as depend mainly on the behavioural choices of the public and banks. This is a useful distinction, analytically as well as for monetary planning. It implies that, for policy purposes, the monetary authority will do well to take the behaviour of as something outside its control and to concentrate its efforts on controlling H to control M. The following figure shows the determination of money supply under H theory. In the figure H is measured vertically and DD are measured horizontally. Since the supply of H is assumed to be given exogenously by the monetary authority at , the curve is drawn parallel to the horizontal axis at the height , showing that is perfectly inelastic to DD. The three demand curves in the market for are upward sloping straight lines going through the origin in accordance with the hypotheses of equations (4), (9) & (10). The curve represents equation (4), with its slope equal to c. [In India at present the value of c is about one. So the curve has been drawn to make an angle of about 450 with the horizontal axis.] The curve represents equation (9). Its slope has ) The the value of ( curve is simply the vertical summation of the curves. Thus, it represents equation (10). The intersection of the curve with the curve gives the equilibrium of the market. That is, at this point the public and banks are fully happy to hold all the amount of the monetary authority chooces to place in the market. In this situation, the equilibrium amount of , is that shown by ; the public holds amount of currency and leaves the balance of , that is, for banks to hold. For amount, this is exactly equal to banks . It will also be noted that, given the function, is exactly the amount of currency the public would like to hold when .

Equilibrium of the H Market