Money Aggregates

The purpose of monetary aggregates is to measure the amount of money available to the
economy at any time. The monetary base (MB or M0) is a monetary aggregate that is not
widely observed and differs from the money supply but is nonetheless very important. It
includes the total supply of currency in circulation in addition to the stored portion of
commercial bank reserves within the central bank.

Money Supply: Definition, Factors affecting Money Supply, High Powered Money and
Money Multiplier.

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.

M1 = CP+DD

Where,

M1= Narrow Money Supply or Monetary Aggregates in narrow term

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.

M2 = M1 + TD

Where,

M2 = Monetary Aggregates in broad term or Broad Money Supply

M1 = Narrow Money Supply

TD = Time Deposit

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

(Source: https://siddhabhatta.blogspot.com)

Some Important Formulas relating practical problems

1. M1 = CP+DD

2. M2 = M1 + TD

3. Required Reserve = Total Deposits (D) ×REQ

where, REQ = Required Reserve Ratio

4. Excess Reserve = Total Reserve - Required Reserve

5. Remainder of Deposit = D× (1 - REQ)

∆𝑅
6. Total Demand Deposit created (∆ 𝑇𝐷𝐷)=
𝑅𝐸𝑄

∆𝑇𝐷𝐷
7. Money Multiplier =
∆𝑅
 1
8. Money Multiplier =
𝑅𝐸𝑄

9. New Level of M1 = Present Level of M1 + ∆ 𝑇𝐷𝐷

𝐶
1+
𝑇𝐷𝐷
10. Money Multiplier = 𝐸𝑅 𝐶
𝑅𝐸𝑄 + +
𝑇𝐷𝐷 𝑇𝐷

Where,

C = Percent of Cash Holding

TDD = Total Demand Deposit
REQ = Required Reserve in %
ER = Excess Reserve
11. Maximum Amount of Deposit = Excess Reserve × Money Multiplier

12. Money Multiplier is the total demand deposits created by one unit of new reserve injected in
the banking system. If money multiplier is 10 times, it implies that one rupee of new reserve
creates Rs. 10 demand deposit in the banking system.